Reading 33: Corporate Governance－LOS b those, management

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CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 33: Corporate Governance
LOS b: Evaluate explicit and implicit incentives that can align management's interests with those of the firm's shareholders.

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If a manager is confident in her abilities, then:

A) implicit incentives such as the manager losing her job act as a complement for explicit incentives, such as stock options.

B) implicit incentives such as stock options act as a substitute for explicit incentives, such as the manager losing her job.

C) implicit incentives such as stock options act as a complement for explicit incentives, such as the manager losing her job.

D) implicit incentives such as the manager losing her job act as a substitute for explicit incentives, such as stock options.

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Answer and Explanation

Stock options are explicit incentives. An example of an implicit incentive would be the manager losing her job. If a manager is confident in her abilities, then she would be willing to accept a higher probability of being fired for increased compensation. In this case, a strong implicit incentive would be accompanied by an attractive compensation package and the two types of incentives would be measured as substitutes.

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Which of the following statements regarding stock options as management compensation is most accurate?

A) When a stock option is out of the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

B) When a stock option is out of the money, the manager has an incentive to take greater risk. When it is in the money, its incentive effect is similar to that of stock compensation.

C) When a stock option is in the money, the manager has an incentive to take greater risk. When it is out of the money, its incentive effect is similar to that of stock compensation.

D) When a stock option is in the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

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Answer and Explanation

When stock options are out of the money, managers have an incentive to take greater risks. The reason is that the option is worthless when the firms stock price is less than the option exercise price. If the option is currently in the money, a stock option is similar to stock in terms of its incentive effect. The only difference is that the option will provide lower compensation (the stock price minus the exercise price) relative to an outright payment of stock.

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Which of the following statements regarding management compensation is most accurate?

A) Bonuses largely reward a managers long-term efforts whereas stock-based compensation reflects more of the managers short-term efforts.

B) Both bonuses and stock-based compensation largely reward a managers long-term efforts.

C) Both bonuses and stock-based compensation largely reward a managers short-term efforts.

D) Bonuses largely reward a managers short-term efforts whereas stock-based compensation reflects more of the managers long-term efforts.

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Answer and Explanation

Bonuses and stock-based compensation complement one another in the executive compensation package. They both serve different purposes. Bonuses, based on accounting figures, largely reward a managers short-term efforts whereas stock-based compensation reflects more of the managers long-term efforts.