Lecture 4

Question 1

What are the four fundamental objectives of management compensation?

Answer 1

• Wealth leverage
  (incentivize management to maximize shareholder value)
• Alignment
  (shareholder = manager interest)
• Retention
  (retain managers via good compensation - even during periods with low performance)
• Shareholder cost
  (limit cost of management)

Question 2

Give the formula for the “wealth leverage ratio”

Answer 2

% change in managerial wealth
/ % change in shareholder wealth

Question 3

What are shortcomings of “threshold” and “cap” on the bonus payout?

Answer 3

• No incentives to implement value-creating projects for managers being in the area of unrewarded performance
  or
• deeply in the area of unpenalized performance

Question 4

GIve the formula for a typical modern EVA bonus plan.

Answer 4

Bonus = target bonus + y * (delta EVA - expected EVA improvement)

Question 5

Limitations of EVA-based compensation for highly cyclical industries.

Answer 5

• difficult to calibrate EVA bonus plan
• trade off between retention problems or excessive shareholder cost

Question 6

Limitations of EVA-based compensation for startups.

Answer 6

• growth & building market share better indicator of long term value

Question 7

Limitations of EVA-based compensation regarding different risk preferences

Answer 7

• mangagers are more risk averse than fully diversified shareholders
• older shareholders tend to hedge their wealth