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If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation...

If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs (that is, the company's performance)? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s intrinsic value? Which would be the better performance measure? Why?

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Expert Solution

The compensation should be linked to the performance of the firm. This would provide a strong incentive to the CEO to perform well. A fixed dollar compensation would not provide a performance incentive.

The performance should be measured by the growth in the market value of the firm. This is because the goal is to maximize shareholder wealth.

It would be easier to measure growth rate in reported profits, because reported profits are not very complex to calculate, and are anyway calculated periodically by the finance/accounting section, and verified by auditors. On the other hand, intrinsic value calculation is a very complex exercise involving a lot of assumptions, judgements and estimates that required a high degree of expertise.

However, growth in intrinsic value would be the better performance measure because it measures the increase in the value of the firm, which is the goal of the board of directors

jeff jeffy answered 1 month ago
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