Executive Remuneration: Examples and Analysis
Executive remuneration is a key tool that is available to shareholders in order to ensure that agency problem is resolved. The agency problem refers to the possibility where the agents (i.e. managers) instead of serving the interest of the shareholders may tend to become self –serving owing to the divergence of interest of the company and the executives. As a result, it was felt that a portion of the remuneration packages of the CEO and other top executives should be linked to the firm performance and given out as bonuses. This would ensure that the executives would take requisite measures to ensure that firm performs well as their own interests and thereby would bring about a reduction in the agency monitoring cost (Ozkan, 2008).
Further, in the recent years there has been a concern on the rising compensation that has been provided to executives. However, a path breaking study on the US executive compensation conducted in 1980’s highlighted that the average compensation levels provided to the CEO’s was comparable to the levels that existed 50 years ago and only adjustments for inflation had been done. Hence, the concern was not the high compensation provided but rather the manner in which the CEO was compensated. It was found that on an average, the increase of $1,000 in the firm value contributed only rise of 6.7 cents for the CEO. Clearly, this indicated that despite the existence of bonuses and variable pay, at the time, the link between CEO pay and performance was found to be quite weak and dismal. Further, the study also indicated that the connection between firm performance and CEO salary was comparable of any other salaried employee (Rappaport, 1988).
As a result of the above study, it was felt that the board needed to compensate CEO’s and executives with stock options so that there is a greater linkage between the wealth creation for the shareholders and the wealth creation for the CEO. Hence, the CEO were given equity options as their salary packages so as to ensure that the executives would have greater incentive to perform better and create value for the firm which would be reflected in the share price. These stock options had a fixed exercise price which was usually the market price of stock at the time of issue of these options. However, a key issue with the stock options which was reflected in the 1990’s was that the share price was not indicative only of the firm performance and other factors such as economic growth, inflation rate and other macroeconomic indicators persisting in key markets also mattered. As a result, when the stock indexes doubled in a short span in the 1990’s, there was significant wealth creation for not only the performing executives but also for the non-performing executives (Jensen and Murphy, 1990).
Linking Executive Remuneration to Financial Data: Risks and Mitigation
This clearly violates the mandate provided by the shareholders whereby the executives should be rewarded for the superior performance of the firm and any value increase of the firm which is not related to the company performance must not lead to higher compensation for the CEO. This issue of excessive payoffs for even the non-performing CEO’s came into existence owing to the manner in which the stock options are structured. It is essential that stock options must be indexed so as not to guarantee any increase or rise in the share price. Currently, the stock options are structured in a manner which does not ensure a close connection between the compensation drawn by CEO and the firm performance. The possible answer to this issue could be indexing whereby the exercise price of the stock options could be linked to a given index by the board (Jensen and Murphy, 1990).
In this arrangement, the exercise price of the stock options would also vary to the same extent as the index. For instance, if the index during a given year has increased by 10%, then the exercise price would also increase by 10%. As a result, the stock option can be exercised only if the price of the company shares during the same increases by more than 10%. The use of these indexed options would allow segregation of the performing CEO’s from the non-performing. However, there could be potential issues of acceptance of these indexed options and hence these need to be structured in manner that the compensation offered under these for performing CEO’s is more than the corresponding amount received in fixed price options. Further, it is also felt that currently since top executives are only given limited options, hence the executives tend to assume high risk so as to provide a boost to the stock price. This can be avoided by providing higher amount of stock options to the CEO’s and other top executives.
There have been various empirical studies which tend to offer insight on the association between the CEO compensation and performance. As per Tosh et. al. (2000), the correlation between the performance and compensation for the CEO was found to be weak. However, the size of the firm and CEO pay reflected higher and significant correlation. However, a contrary result was found by Ozkan (2007) who did research on UK firms and found that that a positive correlation existed between the firm performance and CEO compensation. The study by Brick et. al. (2005) indicated at the corporate cronyism that exists in large firms since there was evidence of collusion between the board members and top management. As a result, the relationship between CEO compensation and performance was found to be negative. Another study aimed at determining the CEO compensation drivers highlighted that the key factors were firm size, independent of board, size of board, ownership structure, independence of the audit committee and ownership concentration. Incidentally, this study failed to find any significant relationship between the CEO compensation and performance. Also, there have been studies such as Guest (2009) which have found that higher CEO compensation is linked to the size of the board and a larger board typically would lead to higher compensation for the CEO.
Empirical Studies on CEO Compensation
It is apparent from the above studies that while the literature on the determinants of CEO salary seems divided but there is ample evidence to suggest that the CEO pay is more driven by various factors related to the board and firm than by the actual performance of the firm. This is quite concerning as there is unanimity with regards to the linkage of the CEO pay with firm performance but the reality does not reflect the same (Shah et. al., 2009).
The given article also needs to be critically analysed in the backdrop of the above discussion and the results highlighted of various research studies that have been conducted in this regards. The current compensation package is quite high as the numbers speak but more importantly it highlights that the board is of the opinion that the compensation can bring about a significant performance in the firm and take it to new horizon. The compensation package highlights the thinking of the board that Elon Musk is absolutely inevitable for the future of the company considering that the package is contingent to Musk assuming a central position in the firm. Even though the package and the underlying targets are quite ambitious, the empirical evidence suggests that the fat compensation package for Musk would not be sufficient for the company to achieve the stated objectives. One of the benchmarks relates to market capitalisation reaching a mark of $ 650 billion which needs to be understood is not completely in control of the CEO and driven by other factors besides firm performance (Melin, Kochkodin and Hull, 2018). For instance, if there is a crash in the stock market or any major global conflict, the stocks would tumble irrespective of the underlying valuation and firm performance. Thus, instead of using market driven metrics like market capitalisation in a big way, it makes more sense to rely on other comparative measures of growth which would be more reliable. Hence, it is unlikely that the ambitious pay package for Elon Musk would alone be effective in ensuring the organisational performance would improve in line with the expectations considering the available literature which paints a rather a grim picture in this regards. Further, given the current standards in equity options payable to CEO, this is likely to set a wrong precedent and may have a spiral impact on the other top corporations which would not be in the interest of shareholders who are already worried about the rising compensation levels of top executives. Besides, linking of pay package to only the financial data potentially sets wrong precedent and risks ignoring of other aspects which would be pivotal for future organisational growth and must be considered. Also, there is vulnerability of financial fraud as has been seen in the present when financial data is fudged up so that the executives can maximise the bonuses. Enron Corporation is an infamous example of the same. It is thus imperative to be mindful of these issues whlle analysing the given offer for Elon Musk by Tesla board of directors.
A Critical Analysis of Elon Musk’s Compensation Package
With regards to the providing compensation to the executives, there are various means besides the traditional salary, bonuses and stock options. One of these could be to offer promotion and offer a position in the board of directors. Additionally, considering the multinational organisations with bases in different geographies, it is possible for the executive to be given more lucrative assignments where the market and geography is bigger and hence a higher responsibility is associated. Similarly, for non-performance in a particular position, the responsibility and nature of the assignments given can be deteriorated especially if the poor performance is consistent (Shah et. al., 2009).
Also, long term incentive plans are also extensively used whereby free shares are given to the executives based on their performance but this is typically linked with a lock in period of staying in the company for a minimum years post the issue. These tend to provide incentive for the executives to stay for the long term while creating value which is in the interest of all the stakeholders. Besides, in certain geographies such as US, tax incentives are also sanctioned by the company on the performance linked pay of executives so as to enhance the total amount of money that these tend to take home. Other job related perks may also be provided as remuneration to executives (Shah et. al., 2009).
The above discussion clearly highlights that there are various means to provide remuneration to the top executives such as the CEO. Further, there are various studies which have been conducted on the subject so as to determine the determinants of the pay along with the impact of the pay on the firm performance. Most of these studies have failed to identify any significant relationship between the firm performance and CEO salary. This relationship has further worsened through the use of fixed price options whereby even non-performing CEO’s can also derive gains due to appreciation in the share options. Further, it has been found that the compensation of CEO is more driven by the board than by the underlying performance. Clearly, this needs to change in the wake of rising concerns from the shareholders and the widening agency gap. Further, the reliance of executive pay purely on financial data such as that suggested in case of Tesla could potentially raise issues as other aspects may be ignored which are pivotal for the long term sustainability of the business. Besides, having a high package for CEO does not provide as a assurance for the high performance especially when the metrics used are linked to market rather than only the firm relative performance.
Alternative Executive Compensation Methods
Part 2
There are several risks associated with linking the executive compensation only with financial data. One of the key risks would be with regards to the business sustainability in the long term. This is because the financial data is primarily limited to the short term and therefore the executives would tend to create value for the shareholders by potentially taking decisions that can adversely impact the ability of the company to survive or maintain competitive advantage over the long term. This is especially the case when social and environmental concerns are kept aside which would be the case when the managers would be exclusively appraised on the basis of the financial performance. The sensitivity to non-financial aspects would decline and decision making would be increasingly driven by the financial aspects.
In this process, the company may alienate key stakeholders who would have wider concerns which would be of interest to the company but the management may choose to ignore the same as the underlying costs would not be witnessed in the short term. This is especially true for resource based industries where the resource may be exploited at the present to deliver superlative results but the performance in the long term would be severely dented. Further, another key in such an environment is that the long term investment in assets such as manpower, R&D, organisational culture may suffer since the financial impact of these is felt over the long term only and in the short run, it is likely that the financial parameters may be adversely impacted. An example of this is the training and other developmental expense on employee which besides enhancing productivity also improves reputation as a employer which would have significant key advantages over the long term. Further, these investments are such that they enable the organisation to stay ahead of the competition and thus are vital. Additionally, the customer can also be ignored owing to which poor quality services or products could be delivered with the intention of leveraging on the brand and maximising sale. This is especially the case in businesses with franchising model.
In order to manage the above identified risks, it makes sense that a balanced scorecard is used for performance management. Besides financial parameters, the balanced scorecard also takes into consideration other factors such as customer focus, organisational growth & learning coupled with improvement in business process. The customer focus ensures that measures are taken so as to enhance the customer satisfaction and ensure retention with the focus not just limited to generating sales. Additionally, the organisational growth is ensured by various parameters related to management of not only knowledge but also human capital which has emerged as a viable source of competitive advantage under the current business environment. This ensures that there is requisite focus and investment of resources towards the future growth and asset building of the company which would safeguard the future growth. Finally, the balance scorecard also ensures focus on internal processes which essentially aim at efficiency so that the interval processes could be improved. These improvements are not directly reflected in the financial statements of the company but could be aimed at achieving other important objective such as employee or customer satisfaction (Jensen, 2001)
PART B
- Since the variable cost is 55% of the selling price, hence the contribution margin would be 45%.
Let the selling price per unit be $ X
Sales volume = $ 687,500
Desired profit = $1,000,000
Fixed cost = $ 687,500
The relevant formula to be used is indicated below.
0.45*75000X – 687,500 = 1,000,000
Solving the above, X = $ 50
- The total costs would comprise of direct material, direct labour along with overhead costs.
Total direct material = $ 1,200
Let the direct labour cost be $X
Considering the given relation between direct labour cost and overhead rate, the overhead cost – 1.75X
Also, total costs = $ 2,506.25
Hence, 1200 + X + 1.75X = 2506.25
Solving the above, we get X = 475
Manufacturing overhead allocated till data would be 1.75*475 – $ 831.25
- Since excess capacity is there, hence the fixed costs are not relevant for the given decision.
Unit variable cost = 7000 (Direct Material) + 2500 (Direct Labour) + 1500 (Variable Manufacturing Overhead) = $ 11,000
A mark up of 50% would be applied on the above cost, hence unit selling price which must be quoted for this special order = 11000*1.5 = $16,500
- IRR is that discount rate for which the NPV comes out as zero.
Thus, cost of the machinery = Present value of savings from the machine over a 15 years period.
The present value formula for annuity is given below.
Cost of machinery = 300000*(1-1.08-15)/0.08 = $2,567,844
- Total initial investment = $ 19,000
Total cash inflows over the first two years = 6000 + 8000 = $14,000
Money to be recovered in the 3rd year = 19000 – 14000 – $ 5,000
Time required in the 3rd year = (5000/7000) = 0.71
Payback period = 2+ 0.71 = 2.71 years
- The NPV of the given project can be found as shown below.
NPV = -19000 + (6000/1.1) + (8000/1.12) + (7000/1.13) + (6000/1.14) + (5000/1.15) = $5,528
- (i) The analysis by the accountant is incorrect on two aspects. One is that the accountant fails to take into consideration the time value of money which is apparent from the fact that the overhaul cost is being distributed equally across all years. Also, the evaluation needs to be based on actual cash flows which is not the case since non-cash expense such as depreciation have also been deducted.
(ii) Since the tax effect is being ignored, hence the depreciation would not be considered as it is only considered on account of the savings that are incurred in tax. The NPV computation using the relevant cash flows during the project useful life is as indicated below.
It is apparent that the NPV of the given project is positive and hence the project must be accepted.
(iii) The IRR is referred to as the discount rate which yields the NPV as zero. This has been computed as shown below.
IRR = 16.36%
Hence, it is apparent that IRR rate is greater than 15%. This could have been inferred even from the positive value of NPV.
- I) The sales budget for October –December 2018 is indicated below.
- ii) The estimated purchase budget for October –December 2018 is indicated below.
iii) The requisite cash budget for October –December 2018 is indicated below.
References
Brick, I.E., Palmon, O. and Wald, J.K., (2006) CEO compensation, director compensation, and firm performance: Evidence of cronyism? Journal of Corporate Finance, 12(3), 403- 423
Guest, M.P., 2009. Board structure and executive pay: evidence from the UK. Cambridge Journal of Economics., bep031.
Jensen, M.C. and Murphy, K. (1990) CEO Incentives – Its Not How Much You Pay, But How, Harvard Business Review, May June Issue < https://hbr.org/1990/05/ceo-incentives-its-not-how-much-you-pay-but-how >
Jensen, M. C. (2001). Value maximisation, stakeholder theory, and the corporate objective function. European Financial Management. 7 (3), 297–318.
Melin, A., Kochkodin, B. and Hull, D. (2018) Musk’s New Pay Deal Could Make Him the World’s Richest Man—If Tesla Succeeds [Online] Available at https://www.bloomberg.com/news/articles/2018-01-23/tesla-tops-ups-all-in-bet-on-musk-with-2-6-billion-option-award [Accessed on May 26, 2018]
Ozkan, N. (2007) CEO Compensation and Firm Performance: An Empirical Investigation of UK Panel Data. SSRN eLibrary. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102703
Rappaport, A; (1988) New Thinking on How to link Executive Pay with Performance, Harvard Business Review, March April Issue < https://hbr.org/1999/03/new-thinking-on-how-to-link-executive-pay-with-performance >
Shah, S.Z.A. et al. (2009) Determinants of CEO Compensation. Empirical Evidence from Pakistani Listed Companies International Research Journal of Finance and Economics, 32, 149-159.
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