Chapter 17 - Executive Compensation and Incentives

Abstract

Modern finance theory argues that the proper objective of managers is to maximize the value of the firm, which in general means running the firm in the shareholders' interests. It begins by examining trends and components in executive compensation. It then discusses what determines incentives, with a particular emphasis on the agency view. Following this, it turns to the discussion of one of the larger puzzles in the literature—the general absence of the use of relative performance evaluation when compensating and providing incentives to top managers. The key limitation on the provision of incentives is the need to share risk between managers and other shareholders. Actual compensation practices reflect this trade-off. A number of well-documented examples are consistent with the rent extraction view of the level of compensation. Instances of excessive compensation and rent extraction seem to be correlated with corporate governance failure, accounting fraud, and poor corporate outcomes. Furthermore, the chapter examines what managerial actions incentives should or do influence and, in turn, the associated impact on firm value. Finally, it takes a look at some alternatives to the agency view, including the increasingly popular skimming or rent extraction view of executive compensation.