Question

Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders.

a. A fixed salary.

b. Stock in the firm that must be held for five years.

c. A salary linked to the firm’s profits.

Short answer

a. Advantage - Allows the manager to focus on the long term vision

Disadvantage - Doesn’t incentivize the managers to maximize the firm’s value

b. Advantage - Managers would try to maximize the stock value as it would add to their wealth too

Disadvantage - Very risky proposition for managers to compensate for risks

c. Advantage - Managers would be most likely to contribute to firm’s profit; Disadvantage - Managers may try to manipulate its earnings

Step-by-step solution

Definition

When managers, who are hired as agents of the shareholders, start pursuing their own interests for a variety of reasons, there arises a conflict of interest between them which are known as agency problems.

Solution for ‘a’

a. Fixed salary-

• Advantages: Since it is not be linked with the success of company (at least in the short term), It will allow the manager to focus on the long term vision of the company and benefits of its shareholders.
• Disadvantages: Since it will be fixed sum of money, independent of firm’s success, it doesn’t incentivize the managers to maximize the firm’s value.

Solution for ‘b’

b. Stock in the firm that must be held for five years-

• Advantages: Since the value of stocks in the firm would be linked to the firm’s success, the managers would try to maximize the stock value as it would add to their wealth too. When the stock has to be held for at least five years, the manager will have no incentive to manipulate the stock prices.
• Disadvantages- Since the value of stocks would be linked to firm’s success; it would be very risky proposition for managers, as he would not get enough diversification to compensate for the associated risks.

Solution for ‘c’

c. A salary linked to the firm’s profit-

• Advantages: Since the salary of the managers would be linked with firm’s profits, managers would be most likely to contribute to firm’s profit.
• Disadvantages: Since the firm’s success would mean more compensation to its managers; the managers may try to manipulate its earnings.