1. In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue th
ID: 2621480 • Letter: 1
Question
1. In the wake of corporate scandals at Enron, Tyco, and WorldCom, some argue that managers of large, publicly owned firms sometimes make decisions to maximize their own welfare as opposed to that of stockholders. Does such behavior create problems in using value maximization as a basis for examining managerial decision making?
2. What are some potential benefits to companies of paying executives with stock options? What are some potential risks to companies of paying executives with stock options?
Explanation / Answer
1.Yes, like virtually all theory, the value maximization model involves some simplification and abstraction from reality. The important question is whether or not the model is realistic enough to provide useful insight into the managerial decision making process. While managers undoubtedly do take their own welfare into account when making decisions, evidence strongly indicates that market pressures provide a strong incentive for managers to act in accord with the dictates of economic efficiency. Furthermore, managers who pursue policies detrimental to stockholder interests run the risk of being replaced following stockholder "revolts" or unfriendly takeovers.
2.Stock options are financial contracts that give the bearer the right, but not the obligation, to purchase shares in a company at a particular price at a particular future point in time. The value of the stock option is equal to the difference between the value of the shares in the stock market and the price of purchase specified in the option contract. Stock options are often used as part of executive compensation plans.
Benefit: Avoids Principal-Agent Problems
The use of stock options creates a commonality of interest between the owners of the shares in a company (the principals) and the senior management of that company (the agents). The shareholders want the price of the shares to grow, and if the compensation of the senior management is connected with the price of the shares, the senior management will also want the price of the shares to grow. If the compensation of the senior management was not connected to the price of the shares in this way, the senior management might pursue goals contrary to what maximizes shareholder value.
Benefit: Incentivization
Because the value of the option is directly tied to the price of the share price of the company the executive works for, options provide an incentive for executives to make decisions that will benefit the company and hopefully cause the price of the shares in the company to rise.
Benefit: No Requirement of Up Front Investment
Unlike conventional investment in companies, there is no need for the individual executive to personally invest in the company in order to receive the benefits that arise from an increase in the price of the shares of that company.
Risk: Market Volatility
One problem with executive compensation using stock options is that the price of shares in the stock market is often volatile. The price may rise and fall because of changes in the business environment that the company operates within, rather than because of changes within the company itself or because of the actions of the senior executives of the company. Smart decisions by executives may go unrewarded if the share price of the company falls due to outside factors or market volatility. It also means, conversely, that poor decisions may go unpunished if the shares go up due to external factors or market volatility.
Risk: Short Term Perspective
The emphasis on increasing shareholder value that stock options create may lead to an undesirable short term perspective on the part of executives. If executives are keen for the share price to increase on a quarter-by-quarter basis, they may make decisions that benefit the share price in the immediate short term but not in the long term. For example, necessary long term investment within the company may reduce profits for a quarter, and adversely effect the share price, but nevertheless be necessary for the long term viability of the company.
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