In its 2004 proxy statement to shareholders, the compensation committee of General Electric Company (GE) reported that in 2003 it had discontinued ESOs for its CEO, Jeffrey Immelt. In their place, GE awarded 250,000 restricted share units. One-half of these units entitle Mr. Immelt to one share each in 2008 if operating cash flow growth, adjusted for the effect of unusual events, increased at an average rate of 10% or more during 2003-2007. Otherwise, the share units would be cancelled. The other 125,000 units entitled him to one share each in 2008 if the total return on GE shares over 2003-2007 meets or exceeds the return on the S&P 500 Index for the same period. Otherwise, the share units would be cancelled. GE's shares were trading for about $30 U.S. at the time of this announcement.

For 2003, Mr. Immelt’s compensation also included a base salary of $3 million plus a cash bonus of $4.325 million. The amounts of cash bonuses are determined by GE's compensation committee upon evaluation of an individual’s performance for the year, including contribution to financial performance. According to the compensation committee, after taking into account cash bonus and restricted share units, more than 75% of Mr. Immelt’s potential compensation for 2003 was at risk. GE also required that its CEO own six times salary in company shares.

Required

a. What balance between short-run and long-run CEO effort is the GE compensation plan likely to induce? Explain,

b. What are some of the dysfunctional effects for the firm of too much risk imposed on a risk-averse manager?

c. One-half of the restricted share units awarded to Mr. Immelt are based on meeting an operating cash flow target. Evaluate the relative precision and sensitivity of operating cash flow and net income as performance measures. Also, evaluate the effects on manager motivation of eliminating “unusual events” from the performance measure.

d. To what extent are the restricted share units awarded to Mr. Immelt based on shareholder return subject to the “pump and dump” behavior that some managers seem to adopt when their compensation is based on ESOs?