Case study 5.2..
- One of the problems in the shareholder/manager agency relationship that pay contracts are designed to overcome is the risk aversion problem. Outline what this problem is, and how the contract between managers and shareholders can be designed to reduce risk aversion. (J, K)
Managers in this case are less likely to invest in projects with greater risks. This is because, if they fail they will lose more in comparison to shareholders. Therefore, the basic reason behind the manager preferring less risk than a shareholder is because their human capital is tangled to the firm, whereas a shareholder is likely to have his investments across a variety of projects. In other words, a shareholder with diversified risks has less to loose as compared to a manager.
One way of designing a contract between shareholder and the manager to reduce the risk aversion by introducing performance-based incentives such as linking bonuses partly to profits. This could encourage managers to take more risky projects. However, other ways could be (1) the direct intervention by the shareholder, (2) the threat of firing, (3) the threat of takeover.
- How does equity as a pay component work to reduce the horizon problem? What role, if any, does accounting information play in specifying the contractual terms of bonus plans designed to reduce the horizon problem? (J, K)
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Equity as a paying component in the form of shares are useful as they encourage managers to improve the long-term performances by taking a long-term focus. By making use of ratios such as shareholders’ return to tie up the greater proportion of manager’s pay to share price movements would likely to be resulting in maximized long-term performance.
The use of accounting information within pay contracts to specify performance targets against which managerial information is assessed dictates the number of shares and/or options to be paid.
- The article discusses a range of non-salary components that are contained within the management compensation packages of top-100 companies. What is the purpose of including non-salary components in executive pay arrangements? (J, K)
The purpose of including non-salary components in executive pay arrangements such as cash bonuses, share options or other equity schemes, mentioned in the case study, is to comply managerial interests with those of the shareholders. If managers are paid just the base (fixed) salary then there would be no incentive for them to maximize the firm’s performance as they would not be having any benefit of growth. Since managers are the self-interested parties they get motivated by some financial rewards, and this is why shareholders wish to align managerial pay with such non-salary rewards. Paying managers shares and options like these ensures that they intend to perform over a longer-term. Likewise, a cash bonus as part of a comprehensive package ensures that managers maximize the short-run profits too.
- Why would managers prefer short-term cash over long-term equity bonuses? Why does this not align with shareholder interests? Explain your answer. (J, K)
Cash being the most liquid would be the manager’s first preference as it is less risky for them to receive short-term cash payments. Moreover, receiving short-term cash payments gives them the flexibility of investing their cash wherever they want. They could buy shares, property, etc. In addition to this managers prefer short-term focus rather than the long-term one and so wish to get awarded on these basis.
Such time horizon does not comply with shareholder’s interests as short-term cash bonuses lead managers to a shorter time horizon for decision making, whereas owners prefer long-term decision making. Also that the managers will not be looking to invest for future growth of the firm, whereas shareholders prefer positive investments for the future.
- Shareholders of Australian entities have the ability to vote to show either their support or dissatisfaction with companies’ remuneration reports. While this is non-binding on the Board, they are obliged to take note of shareholders’ views. Explain why shareholders might choose to vote against reports with too high a proportion of pay as short-term cash bonuses rather than long-term incentives. (J, K)
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Short-term cash bonuses does not implies the long-term focus as required by the shareholders. This is why short-term contracts, and pay with managers are not parallel to the interest of managers with those of the owners.
As per short-term incentives paying out large sums of cash to managers simply means that reduced cash flow in the business etc. Thus, incentive such as cash bonuses is not an indication of a coherent relationship to the shareholders understanding of the goals of the firm, i.e. the long-term growth.
Case study 8.1..
- What is the function of a credit rating agency?
A credit rating agency is the one that provides with the creditworthiness for the issuers, which includes banks, corporations and governments who have debt instruments and obligations. Theoretically agency provides investors with a separate evaluation and assessment of debt securities. When the credit ratings for an issuer is being undertaken, the basic area of consideration is the ability of that issuer to meet his liable obligations in repaying the forwarded sum. In other words, an issuer’s credit rating will affect the interest rate an issuer can borrow in market for securities.
- Why have these agencies prospered?
With the increasing size and the scope of the financial markets, accompanied by the changing roles of baking sector in capital investment allocation the demand for the services of these rating agencies increased quickly.
On one hand, because of the globalization of financial markets, pension funds and mutual funds faced an increase investment opportunities. Moreover, the volatile price swings was making it more difficult for the investors to carry out required research to assess the creditworthiness of different issuers. This was the time where CRA got boom. Due to its standardized and convenient way of problem solving, reliance on ratings provided an important way for the market partakers to overcome the problems of growing complexity and volatility of the markets.
Moreover, after the establishment of the Basel Accords by the bank of international settlements the ratings produced by major agencies were being incorporated into the regulations governing the type of securities institutional investors were allowed to hold. In other words, these regulations simply meant that the issuers wishing to market their securities needed to fulfill a few regulatory requirement. However this widespread practice faced criticism, but was wholeheartedly welcomed by the investors and the financial market.
- Why do credit ratings ‘underpin the world’s financial system’?
It is simply because of the role of the CRAs that these rating have come to an important point in the financial market system. And because of the rating of some world’s largest agencies such as Moody’s and Fitch critically influence the composition of every bank’s statement of financial position.
- Can you offer reasons why credit rating agencies would have valued US sub-prime mortgages as AAA?
One of basic reasons for a CRA to value US sub-prime mortgages as AAA could be that they have been paid by issuers (conflict of interest between rating agencies and the security creator) to do that so they could protect themselves from the competition. Also that, there could be a chance that the CRA might not have foreseen the high default rates for subprime borrowers, which led to the downturn later on. Besides this, as there is a chance of underwriter going another rating agency (competition among agencies), it might be reason that US sub-prime mortgages were rated as AAA. However it is hard to sell a security if it is not rated, an unjust rating could result in sprawling economic effect leading to an economic downturn.
- Why does the author have a low opinion of credit ratings?
As stated in the case study, according to the author, credits ratings have been and still can be of no use. Author states that since agencies rarely disagree with one another, also that they might be paid by the security issuer to fabricate the ratings, and similarly their sinecure protect them from competition these agencies cannot be held liable for padding things. This is why the author have a low opinion of credit ratings.
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Case study 9.1..
- Why would the NZSO wish to smooth income?
As far as NZSO’s revenue is concerned, it is generated from three major sources which comprises of concert sales, sponsorships and government funding. To satisfy the sponsors and government (from which the company gets the funding) NZSO might have wished to incur income smoothing so that it could be justified that the money they got from these resources was utilized in a best possible manner. In other words, it might have become NZSO’s need to smooth income so that it continues to get facilitated from the funding bodies. On the other hand, if NZSO would not have incurred income smoothing it might have faced the opposite consequences because of showing deficits and the inefficiency of the firm in the financial statements.
- Were the earnings management techniques the NZSO used ethical? Explain your answer.
The financial year NZSO finished just in the middle of the concert, half way between where it got them into the difficulty of spreading total costs and income over two financial periods throughout the entire period. Therefore, the techniques of earning management used NZSO were not misleading for users, it was not intended to produce financial data completely inaccurate. In other words, the technique used by the organization were only to ensure that there no periods with a higher surplus followed by another larger deficit. Therefore it seems like the methods used are not unethical.
- What factors would you consider when determining whether such a decision was ethical?