Agency theory suggests that a way to motivate managers to act in the best interests of the owners/ shareholders is to link managerial compensation to performance measures, such as net income or share price. However, such a linkage imposes risk on the manager.
a. Why is it important to control the risk thus imposed on managers? Explain.
b. Explain two methods by which risk imposed on the managers could be reduced. What happens if too much compensation risk is eliminated?
c. Many managerial compensation packages impose restrictions on when managers can sell stock granted to them as a part of their compensation. For example, some compensation packages indicate that restricted stock awards may be forfeited unless the manager continues to work for the firm for a certain number of years after the granting of the award. Discuss the justification behind such restrictions.
d. Inclusion of shares and options in managerial compensation packages has been attributed to the desire of the owners/ shareholders to provide managers an incentive to undertake policies that benefit the firm’s long- term rather than short- term interests. If this is true, why not compensate the manager only on the basis of share return (for example, only by stock options or restricted stock)? In other words, under these circumstances, what is the justification for having a cash or bonus element in the compensation package?