Case Scenario:
Being on the Board of a company is no longer just a situation where a CEO can pack the Board with a bunch of his or her buddies from the country club (with the hope that such Board members will rubber stamp the CEO’s requests). Board members are more likely to be taken to task these days for not administering the proper oversight on behalf of the shareholders.
The shareholders of XYZ Corp are concerned that their Board is not fully looking out for their interests. Currently the Board receives a fixed amount of compensation for each Board meeting they attend, a fixed amount of compensation for each committee that they serve on, and a fixed amount of compensation for each committee meeting they attend. Suppose that this compensation gives them a payment of 80,000.
The shareholders are interested in the firm’s profits (which they believe are highly correlated with the firm’s stock price---the degree of causation being high profits begat high stock prices). The shareholders are risk neutral (because they hold stock in many different companies) and care about the expected profits of the firm. The shareholders realize that profits are influenced by the degree of due diligence practiced by the Board members and by events uncontrolled by the Board, e.g., state of the economy, luck, etc. The table below reflects the profits of the firm under two conditions: the Board practices due diligence in their oversight of the CEO and the Board does not practice due diligence. In addition, profits are shown under three scenarios not under the control of the Board: a good economy, a neutral economy, and a bad economy along with estimates of the probability of each scenario. The profit entries are BEFORE any compensation is given to the Board members.
Board members are risk averse with a utility function of U = W0.5 if they don’t practice due diligence and U = W0.5 – 30 if they do practice due diligence, where W is the compensation received from being a Board member. Practicing due diligence requires that they work harder and this decreases their utility all other things being equal. For simplicity, assume that there is just one Board member.
Good Economy Medium Economy Bad Economy
Probability 0.4 Probability 0.35 Probability 0.25
Practice Due Diligence 1,000,000 800,000 600,000
Don’t Practice Due Diligence 850,000 700,000 450,000
The shareholders are contemplating two new compensation schemes for the Board because they believe that the existing one causes the Board not to practice due diligence. They are listed below:
Plan I: Pay the Board 40,000 per year plus 10% of the before compensation profits, i.e., 10% of the profits listed in the table above
Plan II: Pay the Board 30,000 per year plus a bonus of 100,000 if the before compensation profits EXCEED 700,000.
Are they right about the current compensation scheme? Which of the two new schemes (if any) is better for the firm and why?
They are (right, wrong) about the current compensation scheme
Circle One
because:________________________________________________
( Current Scheme, Plan I , Plan II) is better for the firm
Circle One
because:______________________________