Bonus plans are used to reduce agency problems that exist between managers and shareholders. Discuss two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that should be added to a bonus contract to address the issues identified.
Ans :- • The separation of ownership and control means that managers can act in their own interest, which may be contrary to the interest of shareholders. This can be broken down into a number of specific difficulties:
1): Risk aversion problem:- Managers prefer less risk than shareholders because their human capital is tied to the firm. They prefer to diversify their own risk rather than maximizing the value of the firm through higher risk projects.
2): Dividend retention problem:- Mangers prefer to pay out less of the firm’s earnings in dividends in order to pay for their own perquisites.
3): Horizon problem:- Mangers are only interested in cash flows affecting their remuneration for the period they remain with the firm, whereas shareholders have a long term interest in the firm’s cash flows because share prices equal the present value of shareholders expectation of all future cash flow.
• Bonus schemes can reduce these problems by tying the managers remuneration to an index of the firm’s performance that has a high correlation with the value of the firm (for example, share prices, earnings). This aligns managers and shareholders interest by tying managerial compensation to performance ex ante without the need to rely on ex post mechanism, such as renegotiating salary.
• Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers only after they have achieved an “expected” level of firm profits for a period-then the remuneration will increase as profitability increases, thereby providing incentives for managers to increase their bonus by increasing firm profitability.
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