competency case

7/29/2019 Competency Case

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CASE ANALYSIS

SUBJECT : COMPETENCY MANAGEMENT

SUBMITTED BY,

HIMA BINDU CHENNA

11251008

SUBMITTED TO,

MR. A. VASU DEVA REDDY,

ASSOCIATE PROFESSOR,

KLUBS.


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INTRODUCTION: The increasingly prominent role that equity has played in executive

compensation has resulted in a strong tie between CEO wealth and stock price. Corporate

executives are paid at extremely high levels compared to lower-level employees, especially

in the United States, and their level of compensation usually does not change based oncompany performance with respect to competitors, but rather with changes in their

company's stock price. It is well known that executive compensation among U.S.

corporations is comprised mostly of stock options, sometimes up to 90% of overall

compensation. These stock options allow executives, namely chief executive officers

(CEOs), to cash in big bucks during good times and risk zero losses during bad times. One

way that boards attempt to align their CEOs' interests with the shareholders' is in structuring

the CEO's compensation package. The four basic components that made up approximately

87% of CEO pay for all companies include salary, bonus, short term stock options

(exercisable), and long term stock options (un exercisable).

CONCEPT RELEVANCE: Incentive pay, also known as "pay for performance" is

generally given for specific performance results rather than simply for time worked. A

financial reward system for employees where some or all of their monetary compensation is

related to how their performance is assessed relative to stated criteria. Performance related

pay can be used in a business context for how an individual, a team or the entire company

performs during a given time frame. While incentives are not the answer to all personnel

challenges, they can do much to increase worker performance.

The growing popularity of stock options in executive compensation over the last 10

years has attracted much literature and controversy. Many studies have been performed todetermine the effects of stock option compensation on company performance and

shareholder wealth, resulting in mixed views. Yet, because shareholder expectations are

embedded in the returns that stock options provide, it is very difficult to gain guidance on

this subject from economic theory (Abowd and Kaplan 1999). In addition, as seen through

bonuses, economic theory does not predict that increases in incentives, even stock options,

necessarily lead to an increase in reported earnings (Abowd and Kaplan 1999).


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Stock option grants allow CEOs to purchase a specified number of shares of stock at

some point in the future at a fixed exercise price, known as the strike price (Abowd and

Kaplan 1999). Therefore, recipients of stock options will want the stock price to rise above

the strike price, which is established at the grant date, by the time the option is exercisable(available to purchase). Usually, options have maturity dates of 5-10 years, meaning that the

CEO's right to exercise, or purchase, their options expires anywhere from 5-10 years (Abowd

and Kaplan 1999). Also, most companies do not allow its CEOs to exercise their options

within the first few years of the grant date. Thus, stock options granted today can be thought

of as a long term form of compensation. If the CEO can increase profitability, which in

theory increases the stock price, over the long run, then the CEO will be rewarded once the

options become exercisable. However, most veteran executives already have exercisable

options in their compensation packages, which provide short-term incentives to boost the

firm's stock price. In sum, almost all executives hold a mix of un exercisable and exercisable

stock options (Edgar 2002).

DISCUSSIONS: Wealth sensitivity to stock price, which arises from CEO stock and option

holdings, has increased in tandem with the popularity of stock-based pay. At the same time

there has been growing concern about the cost and effectiveness of equity compensation, as

well as its potential to motivate earnings management . Regulators, shareholder advocacy

groups and the financial press have suggested that stock-based compensation provides

incentives for managers to manipulate accounting results for personal gain. The increasingly

prominent role that equity has played in executive compensation over the past decade has

resulted in substantial CEO equity holdings.

Convexity is a measure of the curvature of the value of a security or portfolio as a

function of interest rates. Using convexity together with duration gives a better

approximation of the change in value given a change in interest rates than using duration

alone. Convexity is used as a risk-management tool, and helps to measure and manage the

amount of market risk to which a portfolio of bonds is exposed. Payout curves with high

convexity may encourage more risk taking, while payout curves with low convexity may

encourage less risk taking. This can be good or bad, depending on the strategy of the

organization. CEO wealth will vary depending on the mix of compensation. Compensation

packages that include a heavier allocation of stock options will exhibit a steeper pay off,


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while those that include a heavier allocation of restricted stock will exhibit a more linear

payoff. The CEO of Southern Co. has a higher compensation package because of allocation

in stock options and hence could take more risk when compared to the CEO of Exelon

whose compensation package comprises of restricted stock.

The CEO of General Mills has convexity in his compensation of 2.98 as the

compensation package involves stock options and hence the curve. The CEO of Kraft has

convexity of 1.18 as it comprises of restricted stock and hence the linear curve. An employee

stock option (ESO) is a call option on the common stock of a company, granted by the

company to an employee as part of the employee's remuneration package. Many companies

use employee stock options plans to retain and attract employees, the objective being to give

employees an incentive to behave in ways that will boost the company's stock price. Another

substantial reason that companies issue employee stock options as compensation is to

preserve and generate cash flow. Employee stock options are mostly offered to management

as part of their executive compensation package. They may also be offered to non-executive

level staff, especially by businesses that are not yet profitable, insofar as they may have few

other means of compensation. Alternatively, employee-type stock options can be offered to

non-employees: suppliers, consultants, lawyers and promoters for services rendered.

Employee stock options are similar to exchange traded call options issued by a company

with respect to its own stock. A compensation package that includes stock options enables

the executive to take more risks thus resulting in an aggressive approach towards taking

decisions. Whereas a compensation package that involves restricted stock restricts the

executive decision making and is confined to avoid risks. Thus a compensation package is

more aggressive if it involves stock options enabling risk taking decisions.

The CEOs of Johnson & Johnson has higher convexity in their compensation i.e. 2.26

as they are awarded with stock options. Also the business of Johnson & Johnson has

diversified products and is operating in different geographical locations, hence they involve

in more risk taking. On the other hand the CEOs of Abbot Laboratories have a lower

convexity i.e. 2.13 in their compensation structure as they are awarded with restricted stock

and also the company is operating on a single unit of business and produce products that are

of similar nature. Hence they are risk averse in taking decisions regarding future growth


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prospectus and hence the linear slope. Thus a diversified healthcare model require more risk

taking than a pure-play pharmaceutical model

CONCLUSION: While options may be the means by which CEOs amass stock holdings,

option wealth effects do not appear to motivate earnings management. In fact, use of both

income-increasing and income-decreasing accruals declines in option sensitivity suggesting

it may reduce managerial aversion to earnings volatility. The compensation of executives of

public corporations is a compelling issue with strong political overtones. When one looks at

compensation and its components in detail, a number of features stand out. To start with, the

distribution of total compensation is highly skewed so averages are highly misleading. The

dispersion of the crosssectional distribution is also remarkable. Measuring the relation

between change in CEO wealth and shareholder returns is one method shareholders and

stakeholders can use to determine whether compensation contracts are appropriate. While it

is reasonable for a CEO to increase wealth at a faster rate than shareholders (because

executives are asked to make strategic decisions), it is not clear what the ratio of this

relationship should be. The executive compensation package has differing effects on

employee motivation and risk, as well as different costs for the corporation. A well-designed

executive compensation plan is important because it rewards both executives and

shareholders, whereas a poorly designed one wastes corporate resources without motivating

the executive.

competency case

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