0b5cbModule 1 Introduction Cntd

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Amity School of Business

Stock Holder Vs Bondholder

Theory PracticeThere is no conflict of interest

between stockholders and

bondholders

Stockholder may maximize

their wealth at the expense of

bondholders:

Taking riskier projects than

agreed.

Borrowing more on the same

assets.

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Firms and Financial Markets

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Theory PracticeFinancial markets are efficient. Managers suppress information.

Managers are honest and

convey full information to

financial markets.

Managers delay the releasing of

bad news.

Financial markets are reasoned

judgments of true value.

Managers sometimes reveal

fraudulent information.

Some argue that markets are

short sighted.

Analysts recommendations are

not always unbiased.


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Firms and Society

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Theory PracticeThere is no costs associated

with firms that can not be traced

and charged to the firms.

Financials decisions can create

social costs and benefits where;

A social costs or benefits is a

cost that accrues to society as a

whole not to a firm that is

making a decision.

These costs and benefits are

difficult to quantify.


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Given these agency problems, is stock price

maximization really the best objective?

Alternate objectives:

Maximize earnings.

Maximize market share.

Maximize firm size.

Do these serve us as a better objective?

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Maximize stock price subject to?

Maximization objective function is internal selfcorrection mechanism. Excess on any linkages lead, if

any unregulated counter actions which reduce or

eliminate these excesses.

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Response to Agency Problems

Bondholder Protection

Restrictive covenants.

New type of bond issue.

More hybrid bonds.

Financial Market response

Regulatory changes.

Increased importance of ethical behavior.

Increased availability of information and ease of trade.

Societal response

Catering more socially conscious clientele.

Growth of social responsible funds. 6


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Management compensation

andMeasurement of Performance

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Executive Compensation

Key elements: Salary.

Benefits.

Incentive Compensation.

Generated lot of debates among legislators, corporate observers,economists, journalists and management experts.

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Conflict of Interest

Agency theory has examined the problem from separation of

ownership from control in public co.

According to Lambert Larcker :

Principal sources of conflict: Excessive perquisites.

Differential interest attitudes.Varying with time horizons.

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Failure to promote value creation

Linkage between size and pay.

Emphasis on short term performance.

Reliance on accounting measures.

Alfred Rappaport Thedysfunctional consequences introduced bythe increased pay increased size philosophy and theoveremphasis on the short term results are exacerbated by the

universal use of accounting numbers for assessing both short

and long term performance.

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Objectives for Executive compensation

policyStephen OBryne identified 4 objectives:

Alignment Managers.Strategies, action, investments, actions that maximise shareholder

value.

LeverageWork harder, take risk, do unpleasant things.

Retention.Incentive sufficient to retain them.

Shareholder cost.Level where shareholder wealth is maximised. 11


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Designing an Incentive Compensation

Plan

A well conceived incentive compensation plan goes a long way in

aligning the interests of managers and shareholders.

Integrate the Incentive plan into the total compensation

Architecture.

Choose the Appropriate Level of Risk Posture and Time

Focus.


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Use Objective criteria

Select the right set of performance measures.

Reward relative measures.

Discourage parochial behavior.

Abandon attempts to measure what executives control.

Lengthen the Decision making Horizon of the Executives.

Employ Stock Options Judiciously.

Ensure tax Efficiency

= Post tax benefit to manager

Post tax cost to the company

Designing an Incentive Compensation Plan


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ESOP

EligibilityNot a promoter, not a director who holds more than 10% of

the outstanding Equity Shares.

Compensation committee consisting of a majority of

independent directors, for advice and supervision of the ESO

scheme.

No ESOS unless shareholders pass a special resolution.

Pricing

Lock in period and rights of the option holder.


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SEBI Guidelines for ESOS

Eligibility.

Compensation Committee.

Shareholder Approval.

Pricing.

Lock in period and rights of the option holder.

Accounting treatment.

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Performance Measurement

Robert W Hall:Performance measurement is the basis of every system in a

company:

Cost systems.

Planning systems.

Capital budgeting systems.

Personnel assignments.

Promotions.

Reorganisations. Budget allocations.

- the mechanisms built up over years by which everything runs.

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Rationale for business performance

measurement

Heightened competition.

Growing empowerment.

Quality awards.

Expanding organisational roles.

Greater external demands.

Power of information technology.

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Comprehensive value risk framework

Total shareholderreturn (TSR). Market valueadded (MVA). Discounted cashflows (DCF). Economic valueadded (EVA).

Economic Profit. Cash flow returnon investment(CFROI).Cash value added(CVA). Return on investedcapital (ROIC).

Return on Assets(ROA).Earnings beforeinterest taxesdepreciation andamortisation(EBITA).

Cash flow. Earning per share(EPS).

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Non Financial Measures

Customer Satisfaction Index

Customer Return

Market share

New product Introduction

On time Delivery

Manufacturing cycle time

Defects Percentage

Throughput

Employee Productivity Index

Patents Obtained

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S h d k N Fi i l M


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Strengths and weaknesses- Non Financial Measures

Strengths Directly traceable to key success factors: Customer satisfaction,

market leadership, manufacturing excellence, Quality etc.

Actionable.

Predict better picture of cashflows.

Weaknesses Difficult to assign rupee value to improvements in non financial

measures. Conflict with each other.

Managers may resort to gaming.

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0b5cbModule 1 Introduction Cntd

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