Case 1:

The existence of high agency costs sometimes prompts firms to financially restructure themselves to achieve

higher operating efficiencies. For example, the lawn products firm O.M. Scott & Sons, previously a subsidiary of

ITT, was purchased by the Scott managers in a highly leveraged buyout (LBO). Faced with heavy interest and

principal payments from the debt-financed LBO transaction and having the potential to profit directly from

more efficient operation of the firm, the new owner-managers quickly put in place accounting controls and

operating procedures designed to improve Scott's performance. By monitoring inventory levels more closely

and negotiating more aggressively with suppliers, the firm was able to reduce its average monthly working

capital investment from an initial level of $75 million to $35 million. At the same time, incentive pay for the

sales force caused revenue to increase from $160 million to a record $200 million.

Case 2:

As a representative example of a performance-based pay package, General Electric CEO Jeff Immelt had a 2006

salary of $3.2 million, a cash bonus of $5.9 million, and gains on long-term incentives that converted to stock

options of $3.8 million. GE distributes stock options to 45,000 of its 300,000 employees, but decided that one-

half of CEO Jeff Immelt's 250,000 "performance share units" should only convert to stock options if GE cash

flow grew at an average of 10 percent or more for five years, and the other one-half should convert only if GE

shareholder return exceeded the five-year cumulative total return on the S&P 500 index. Basing these executive

pay packages on demonstrated performance relative to industry and sector benchmarks has become something

of a cause clbre in the United States. The reason is that by 2008 median CEO total compensation of $7.3

million had grown to 198 times the $37,000 salary of the average U.S. worker. In Europe, the comparable figure

was $900,000, approximately 33 times the median worker salary of $27,000.9 And similar multipliers to those

in Europe apply in Asia. So, what U.S. CEOs get paid was the focus of much public policy discussion even before

the pay scandals at AIG and Merrill Lynch/Bank of America in the fall of 2009.

Question:

Based on the cases above, to mitigate agency problems between senior executives and shareholders, should

the compensation committee of the board devote more to executive salary and bonus (cash compensation) or

more to long-term incentives? Why? What role does each type of pay play in motivating managers?