CASE STUDY: The Debate over CEO Compensation
The most visible and highly paid person in most corporations is the chief executive officer (CEO). CEO compensation is particularly important to firms for three reasons. First, the compensation package is likely to be important in attracting and retaining good CEOs. Second, the form of the pay contract is likely to help determine whether the CEO focuses on value maximization or some other objective. Third, employees throughout the organization carefully follow their CEOâ??s pay. Important morale problems can occur when employees think that the CEO is overpaid. For instance, employees complain bitterly when they are asked to take pay cuts because the company is in trouble, yet at the same time the CEO gets a big raise.
Controversy over CEO pay has increased substantially in recent years. One charge is that the level of CEO pay is too high. CEO pay is so huge that people donâ??t believe they deserve it. It is easy to pint to many ECOS who report compensation in the millions of dollars (reported compensation figures typically include salary and bonus payments, as well as gains from the exercise of stock options). Consider the following two examples. Investors were outraged when E Trade Group Inc. disclosed it had paid out a $77 million compensation package for CEO Christos M. Cotsakos in 2001- a year in which the financial-services company lost $242 million. When Cotsakos pledged later to return $21 million, the complaints hardly subsided. In 2001 Qwest Communications posted a $4 billion loss and employees were laid off. However, Qwestâ??s CEO, Joseph Nacchio, received a $1.5 million bonus, $24 millions in cash, $74 million in exercised options, and was granted 7.25 million in new options. In 1980, CEO compensation was 42 times that of the average worker. In 2000, it was 531 times.
The second major criticism of CEO pay concerns how CEOs are paid. Critics argue that CEOs are agents of stockholders and that CEO pay should be based heavily on stock-price performance. In some celebrated cases CEO pay appears disconnected to CEO performance. For example, Ford Motor Co. reported $5.45 billion loss in 2001. Workers were laid off, and salaries for nearly everyone left suffered. Even though former Ford CEO Jacques Nasser was fired, he still received about $20 million in compensation for the year. Since 1980, the increasing use of stock options has boosted the sensitivity of the average CEOâ??s wealth to firm performance. However, the absolute sensitivity of CEO wealth to performance remains small. Research indicates that for a $1,000 change in firm value, the wealth of the average CEO of a large public corporation changes by only about $10.57. Some argue this relation (which is equivalent to the CEO owning 1.057 percent of the common stock) is too small and that most companies would be better off if they increased incentive pay for CEOs. Some support for this view seems to come from studies that document an increase in stock price when companies announce that they are increasing incentive pay for CEOs.
Question 1. Do you think the fact that most CEOs are paid so much more than rank and file employees suggests CEOs are overpaid? Explain.
Question 2. Japanese CEOs generally receive much lower levels of compensation than CEOs in the US. Does this imply that US CEOs are overpaid?
Question 3. It is obvious $10.57 per thousand is too low of an incentive pay for CEOs? Explain.
Question 4. Does the observation that the stock price increases when the firms increase incentive pay for CEOs suggest that most CEOs do not receive enough incentive compensation?explain.
Question 5. Are they any reason any reasons why overpaying CEOs might be in the shareholder s interest?
Parkleigh Pharmacy is a small department store in Rochester NY, specializing in upscale, expensive personal accessories like sunglasses, beauty aids,leather goods, and home decorations like crystal,china,table lamps. Kaufmann s is a large department store chain based in Pennsylvania with several stores in the Rochester area. Kaufmann s carries broader range of products and caters more to middle income consumers.
Salespeople at Parkleigh are paid a straight hourly wage it does mean no commisions. In addition, they are entitled to a 30 percent discount on anything they buy at the store. By contrast, salespeople at Kaufmann s are paid an hourly wage which means lower than the the hourly wage paid at Parkleigh, plus a commission of 5 percent on sales they make. They receive no discount on product the buy at Kaufmann s.
Question 1. Why do you think the compensation plan differ at the two firms? In particular why do you think Kaufmann s pays commission to salespeople, while Parkleigh does not? Why does Parkleigh offer employees discounts on purchases, while Kaufmann s does not?
Question 2. Assume for the moment , that neither store pays sales commisssions. Parkleigh offers hourly wage plus the employee discount. Kaufmann s offers only an hourly wage. Do you expect Kaufmann s hourly wage to be higher or lower than Parkleighs? why?