Advanced Corporate Finance - Section-A

Introduction to Executive Compensation

Executive compensation also referred to as pay for executives is designed for the business leaders specifically or the senior management and executive employees of the firm. The pay package of the firm consists of various variables that include stock options, base pay, bonus, performance appraisal stocks etc (Edmans, Gabaix & Jenter, 2017). Compensation pay for the executive of high street clothing company will merge the interest of the shareholders with the pay package. This will bring a better performance of the executive in the company.

The 3 main objectives of the shareholders from the executive are:

  • To increase the prices of shares for the next 5 years.
  • The company has lost around 1,500,000 pounds through theft and the shareholders want to reduce the theft.
  • The company has a website that attracts around 16% of the sales while the competitor's website attracts more than 18% of the sales through the website. Shareholders want their sales to increase through the website of the company.

A) The combination of the most appropriate package for providing incentives to the manager includes Base pay, Annual bonus, and performance shares.

Base pay: Base pay includes the sum that is paid to the executive every month. It is stated in an annual format but the payments are divided into months or weeks or any other pattern being followed in the company. It is the initial salary for the person and does not include any benefits, raises, or bonuses. Base pay in the company will be paid every month. This is the payment that helps the employee in their survival and fulfils their daily needs. These payments are received after every month's interval. Also, there are certain deductions like tax and PPF that are deducted from the base pay every month. So, base pay is one of the important components of the pay package for an employee.

Annual bonus: Annual bonus refers to the compensation that is paid over and above the base salary of an employee. These bonuses are ties with the performance of an employee and the amount varies depending upon the milestone that an employee achieves (Bettis et al., 2018). These are paid in a lump-sum to the employee for the hard work they have undertaken and also the dedication they have shown throughout the year. An annual bonus here can be linked to the achievement of the shareholders' objective. These are paid once in a year to the employee or the executive.

Performance shares: There shares are allocated to the managers or executives if the performance area that is wide for the company is met (Edmans & Gabaix, 2016). Here the criteria are improving the performance of shares. Shareholders want a rise in the share performance of more than 1.25% which is predicted to grow without taking any actions. But, the executive will be motivated in this direction to perform only when they will be incentivized. Thus, performance shares will help in improving the goals of the executives.

These are the 3 components that will be included in the payment of an executive. Each part will be paid when certain duties are fulfilled by the executive. Annual bonuses and performance shares will be linked to the objectives of shareholders and will help in the growth of the company.

B) Features attached to the compensation component determining the performance standard and the incentives that will be provided:

Base pay: The base pay of the company will be paid according to the normal duties that will be conducted by the executive (Foster, 2016). It will be depending on the number of days for which the employee has worked. If the payment is paid according to the hourly basis then it will be calculated according to the hours worked by the executive. If an employee takes a leave for more than 2 days in a month except for the Sundays, then every holiday will be marked as a leave against pay and per day salary of the employee will be deducted. If the employees fall sick and have a balance of medical leaves than they will be given medical leaves where the pay of the employees will not be deducted. Thus, base pay will be the overall pay that will be transferred to an employee. Also, the tax deductions for the month and provident pension fund will be subtracted from it. PPF will be depending on the employee. If the employee opts for PPF deductions more than they are required to than as per their instruction that amount will be deducted accordingly. These will be the features of the base pay for the executive that is being hired.

Annual bonus: Annual bonus will be linked to the fulfilment of the objectives of shareholders. Two objectives of the shareholders will be linked to the bonus for the employee (Gao, Hwang & Wu, 2017). This includes a reduction in theft and an increase in the share performance of the company. Bonus will be paid in a mix of stocks or shares and cash. Shareholders are expecting a rise of more than 2.5% in the share prices as this rate will be achieved even when the executive does not take any necessary steps. Also, there was a theft from shoplifting of around 1,500,000 pounds from the company. Shareholders want to reduce that. The annual bonus will depend on how effectively the executive can control these two.

Bonus will increase or decrease according to the increase in share price and reduction in theft. Various categories will be defined and accordingly, it will be paid. The various categories for the shares will be as follows:

  • The first category will be if the executive has reduced the theft by 20% to 40% and there is a growth of 2% in the shares than 50% of the total cash bonus and 25% of the shares will be provided.
  • The next will be when theft is reduced by 50% to 70% and there is a growth of 3% in the shares than 70% of the cash bonus and 40% of the stocks.
  • The third category will be when theft is reduced by more than 70% and the growth of shares shows more than 3% than 100% of the cash bonus and 50% of the shares.

Performance shares: Performance shares will be linked to website traffic. The executive will be able to get the performance shares when there is an improvement in the traffic of the company. At present, the sales through the website are 16% while the competitors are making more than 18% from the websites. New website development is being done by the executive. The performance shares will be given according to the following conditions:

  • If the traffic of the website is at 18% to 20% than 30% of the overall budget of shares will be allotted to the executive.
  • If the traffic ranges from 21% to 28% than 40% of the overall budget of shares will be given to the executives.
  • If the traffic at the site is at 29% or more than 50% of the overall budget of the shares.

C) Compensation package if the cost is at 1100000 of cash and 10000 shares are to be provided to the executive.

Shares will be bifurcated into 2:50% of overall share i.e. 5000 will go down to Bonus package while 50% will be given in the performance package.

Component

Amount

Division

Base pay

600000

None

Annual bonus

- Cash 500000

- Shares 5000

- Theft reduced by 20% to 40% and there is a growth of 2% in the shares then the payment:

Cash- 250000

Share: 2500

- Theft is reduced by 50% to 70% and there is a growth of 3% in the shares

Cash- 350000

Shares: 4000

- theft is reduced by more than 70% and growth of shares shows more than 3%

Cash: 500000

Shares: 5000

Performance shares

5000 shares

- The traffic on the website is at 18% to 20%

Shares: 3000

- Website traffic ranges from 21% to 28%

Shares: 4000

- The traffic at the site is at 29% or more

Shares 5000

In this manner compensation package will be decided. Annual bonuses and performance shares will be given according to the target that has been set and achieved by the executive. This will help the company in providing the package according to the performance while including a regular payment to the executive.

Conclusion on Executive Compensation

The pay package of an executive should include a variety of factors. Certain bonuses should be linked to the performance of the employees. This will keep them motivated for performing. Annual bonuses and performance shares are the measures that will be linked with the performance of the executives and they will get it only when they perform. While basic pay is paid for the regular duties that are performed by the executives daily. This will create a balance and will help in achieving and linking the goals of both the shareholders and also the executives. If an executive wants to earn more than they have to perform better. Hence, the compensation package will be appropriate.

Advanced Corporate Finance - Section-B

Q 3. Are dividends irrelevant? Main arguments for and against the irrelevance of dividends?

Introduction to Dividends

Dividends refer to the portion that is distributed among the shareholders of the company. It is decided by the board of directors whether the dividends are to be distributed or not. Dividends are mostly issued through cash yet they can also be distributed in the forms of shares and stock of the company. With that, they are also paid through the mutual funds or exchange-traded funds of the company (Hameed & Xie, 2019). Dividends serve as a token reward that is paid to the shareholders for the investment they have made in the organization and it is paid only when the company earns a profit. The payout rates and timings are different as chosen by the directors of the company. Dividends are considered as irrelevant by a theory from Modigliani and Miller.

Irrelevancy of Dividends

Modigliani and miller theory provide a major argument for the irrelevancy of dividends. According to their concept, investors do not check or pay heed to the history of dividends of the company. So, while calculating the valuation for the company, dividends do not play any part.

The theory was proposed in the year 1961. Modigliani and Miller suggested that the capital gains in the prices of investments are equivalent to the dividends. The impact on the valuation of the company is only created by its earnings that are a result of the investment policy of the company (Ostaszewski, 2019). So, as per them once the investor is aware of the policy of investment, they do not pay attention to the dividend history of the company. The irrelevancy of dividends can be justified by the argument that once the dividends are distributed to the shareholders than the price that could have been increased by the capital gain decreases due to loss in capital. This nullifies the gain for the investors.

For example, whether the company pays a dividend or not, investors can always have their cash flows from through the stock as per their need. If the investor needs money, he can sell a part of its stock and if dividends are not spread out then share value will be high. This will help him get better returns. While, if the investor has no requirement of cash than dividends will only reduce the capital appreciation that they will be getting (Babatunde & Adedokun, 2017). Thus, dividends are irrelevant for the investors.

Dividends do not serve any purpose for the investors as investors always have an option to sell a part of their equity for cash gain as explained above. Yet when the dividends are issued, it creates a negative impact on the value of shares. The amount could have been used for the appreciation purpose of the capital that might have increased the value of the share and lead to rises in the price of the share, instead it has been distributed that has led to a loss in the value of shares. It might have gotten covered by the dividends that are received for the shareholders but that is irrelevant (Udobi & Iyiegbuniwe, 2018). The company could have directly invested in the shares and led to better results than giving it to shareholders for no use.

Distribution of dividends or the history of the same is not considered by the investor when they are planning to invest. Dividends do not create an impact on cash flows. They are distributed out of the free cash left with the company. Yet their distribution affects the share prices which affects the decision of the investors. Also, while distributing dividends an organization spends a lot of time pondering over the issues. This leads to a waste of time too on a thing that is not even considered by the shareholders.

Thus, Dividends are irrelevant as pointed out by Modigliani and Miller and the arguments presented were that the stakeholders do not consider the dividend return while valuing a company. The next is that the stockholders always have an option to sell a part of their stock to fulfil their need for cash. The amount that is being distributed can be utilized in the appreciation of the capital value of shares. Also, when the company issues dividends then the price of the stock falls, this makes investors lose the value of their money. Hence, dividends are irrelevant.

Against the Irrelevancy of Dividends

Dividends are relevant, these arguments are given by Walter and Gordon. As per them, the policy of dividend creates a positive impact on the position of the firm in the share market. In their theories, they state that paying out dividends that are higher will increase the stock value while low dividends will reverse the effect. The more the company pays out as dividends, shows that it is making more profit in the market (Dedman, Jiang & Stark, 2017). According to the approach of the Walter, policy of dividend always affects the goodwill attached to a company. According to the model of relevancy by Walter, dividend policy establishes a relationship between the return on investment of the firm or the return rate that is internal and the capital cost or the rate that is required. Take r = internal return while k = cost of equity.

So, when r is greater than k then firms are considered as growth firms and will have an optimum policy of dividend that would plough back the earnings that have been made by the company. In this scenario, 0 payment of dividends will work as it will help in maximizing the share value in the market. However, in the case where r is lesser than k and firm do not have an opportunity that is positive for the investment option than it is better than the dividends are distributed so that shareholders can attain better results by investing them at other places. Gorden too has suggested the relevancy of dividends by stating that the value of the dollar from the income of dividends is more than the gain of capital that will be achieved by the shareholder. Dividend income will be in the present while the capital gains will have uncertainty attached to the. As per his statement, the market value of the share is the present value for the stream of future dividends.

These arguments prove the relevancy of dividends. The company that pays for dividends indeed has a better image in the market. It depicts that the company is generating profits over and above the required level. The company or the board decides to pay off dividends only when they have enough cash with them. So, when the dividends are paid out, it depicts the good financial health of the company (Jahmani et al., 2017). As the goodwill improves, it brings overall benefit for the company like more investors will be attracted to the company. So, dividends are relevant. Also, the equation is correct. If the cost of capital for a company is more than the rate than it is better to disburse the amounts or else, there will be no gain attached to the shareholders.

The present value of dividends that will be received will be higher than the future capital gains. If the gains are discounted at present value than dividends will be in a better position as the same amount will be received in later years. Also, as per a general time value theory of money, $100 at present has more value than $100 after two years. With that, the capital gains that will be made are subject to various risks that are present in the market. There are chances that in the next quarter market changes and the company suffers a loss (Harakeh, Lee & Walker, 2019). Then the gains that have been made will also be lost. So, not paying the dividends will put that income on risk with regards to various factors that are no controllable.

When a dividend is paid the shareholder will have more benefit rather than having an overall appreciation of capital. In that, all the shareholders who are not involved in the dividend benefits will also get involved. This will divide the profits of the shareholders among various other shareholders and reduce the gains that they would have received if the dividends were paid. Thus, these arguments prove the relevancy of dividends in the market.

Conclusion on Dividends 

There is no definite conclusion that can be drawn from the irrelevancy or relevancy of dividends. Every firm has its opportunity and losses according to the market condition in which they function. It would be better for certain companies to pay off dividends while for some it will be a tiresome process and will bring no good. Thus, the irrelevancy and relevancy of the firms depend on the requirement and the purpose they want to solve with the distribution of dividends. If the company can generate more returns by not distributing the dividends than they are irrelevant and if the company cannot generate better results by ploughing back the dividends than they should pay the shareholders. This is because they can invest their gains somewhere else and can earn better returns.

References for Dividends

Babatunde, A. A., & Adedokun, B. K. (2017). Dividend Policy: A Review of Literatures and Empirical Evidence. Singaporean Journal of Business, Economics and Management Studies51(5379), 1-8.

Bettis, J. C., Bizjak, J., Coles, J. L., & Kalpathy, S. (2018). Performance-vesting provisions in executive compensation. Journal of Accounting and Economics66(1), 194-221.

Dedman, E., Jiang, W., & Stark, A. (2017). The value relevance and information content of cash and stock dividends in China. The European Journal of Finance23(7-9), 648-673.

Edmans, A., & Gabaix, X. (2016). Executive compensation: A modern primer. Journal of Economic Literature54(4), 1232-87.

Edmans, A., Gabaix, X., & Jenter, D. (2017). Executive compensation: A survey of theory and evidence. In The handbook of the economics of corporate governance (Vol. 1, pp. 383-539).

Foster, D. (2016). Taxing executive share incentives: the rules need to change: features-corporate tax domestic. TAXtalk2016(60), 38-39.

Gao, Z., Hwang, Y., & Wu, W. T. (2017). Contractual features of CEO performance-vested equity compensation. Journal of Contemporary Accounting & Economics13(3), 282-303.

Hameed, A., & Xie, J. (2019). Preference for dividends and return comovement. Journal of Financial Economics132(1), 103-125.

Harakeh, M., Lee, E., & Walker, M. (2019). The effect of information shocks on dividend payout and dividend value relevance. International Review of Financial Analysis61, 82-96.

Jahmani, Y., Choi, H. Y., Park, Y., & Jiayun Wu, G. (2017). The value relevance of other comprehensive income and its components. Revista Internacional Administracion & Finanzas9(1), 1-11.

Ostaszewski, A. J. (2019). Subdominant eigenvalue location and the robustness of dividend policy irrelevance. In Ulam Type Stability (pp. 273-324).

Udobi, P. I., & Iyiegbuniwe, W. I. (2018). A Test of Miller and Modigliani Dividend Policy Irrelevance Theory in the Nigerian Stock Market. American Finance & Banking Review2(2), 1-13.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

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