Theory, An Optimal Executive Compensation Scheme Essay

In theory, an optimal executive compensation scheme overcomes the principal-agent problem by aligning the interests of executives and shareholders, and subsequently providing executives an incentive to maximise shareholder value. Furthermore, an executive compensation scheme must be sufficient to attract and retain the appropriate executive. According to Bognanno (2014), restricted stocks and stock options are the most common forms of equity-based compensation schemes, with stock options accounting for almost half of US CEO compensation in 2000. Since economic agents respond to incentives, the intuition behind equity-based compensation schemes is that providing executives with a form of compensation that is tied with the performance of the company, will provide an incentive for the executive to maximise shareholder value. For instance, assume an executive is provided with a stock option of 100 stocks with a strike price of $10, the executive will only receive a payoff if the stock pr ice is above $10 (see Figure 1). If the stock price is above the strike price, the executive is able to exercise the option by purchasing the stock at $10 and selling the stock on the spot market. Since the executive has an incentive to maximise his or her payoff, the executive’s interests are in theory, aligned with shareholders and the executive is expected undertake activities which maximises shareholder value. DiPrete et al. (2010) suggest that executive compensation practices cannot beShow MoreRelatedControl Oriented Theories, Managerialism And Agency1571 Words   |  7 PagesControl Two relevant control-oriented theories, managerialism and agency, are explored by (Tosi, H., Werner, J. Katz J. and Gomez-Mejia, I., 2000). 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I broadly explore the question by examining several common criticisms of CEO pay through both philosophical and empirical lenses. While some criticisms appear to be unfounded, the analysis shows not only that current compensation practices are problematic both from the standpoint of distributive justice and fairness, but also that incentive