Thomas Hemmer

Optimal exercise and the cost of granting employee stock options with a reload provision

In this paper we formulate a theoretically correct valuation method for estimating the cost to a firm of granting reload options (REOs) to its employees. The model developed in this paper can be used directly by firms who wish to apply Statement of Financial Accounting Standards (henceforth SFAS) No. 123 [1995] to REOs. Also, the model is directly useful to the FASB should they choose to require the entire value of REOs to be estimated at the date of grant, a requirement that was not included in SFAS No. 123 due to the lack of a reasonable valuation model.1 REOs, which have been gaining in popularity since the late 1980s, are similar to traditional ESOs, except that they also carry a reload provision.2 The reload provision specifies that if the option holder exercises

Informational costs and benefits of creating separately identifiable operating segments

We provide an informational theory for how the ownership claims to a firm might be structured. When the market price of equity provides valuable contracting information there is a benefit to creating separate ownership claims to each of a firms divisions. However, creating this information also generally has adverse incentive effects because it enriches the agents strategy space. We show in a complete contracting setting that under a large class of agencies the firm is strictly better off bundling the ownership claims to divisions that are sufficiently similar and creating separate ownership claims only to divisions that are sufficiently different.

On The Subtleties of the Principal-Agent Model

In this essay I focus on the equilibrium relation between the “risk” in a performance measure and the “strength” of the controlling agent’s “incentives.” The main motivation is that a large (mainly empirical) literature has developed postulating that the key implication of the principal-agent model is that this relation be negative. I first show that a standard principal-agent model, e.g., Holmstrom (1979), offers no equilibrium prediction about the relation between “risk” and “incentives.” Next, I show that except in the highly stylized limiting Brownian version of Holmstrom and Milgrom (1987), this model doesn’t yield a directional prediction for the equilibrium relation between “risk” and “incentives” either. This is due to the general property that risk arises endogenously in such principal-agent models. This, in turn, establishes that while the mixed empirical evidence on this relation may be useful from a descriptive vantage point, it does not shed any light on the validity of the principal-agent theory.

Analytical Modeling of Cost in Management Accounting Research

Abstract The advantage of analyzing the highly complex economics of a firm by means of a model is the simplicity of the model. Historically models of cost have developed from simple models under certainty to models incorporating uncertainty and strategic behavior. Models of cost are constructed with either a product cost focus or a stewardship focus. As the focus of the problem changes the model changes dramatically as some dimensions are highlighted and others are dimmed. This represents the challenge of the model constructor. The chapter will illustrate these facets of building and using analytical models for analysis of cost.

On the Use of Loose Monitoring and Lavish Pay in Agency

In this paper, we study a setting where a firm (principal) is privately informed of the firms potential and contracts with an agent to supply unobservable effort. We show it can be optimal for the firm to have loose monitoring in the sense that the monitoring system is less perfect than what is implied by a standard agency model a la Holmstrom (1979) and to provide lavish pay in the sense that the optimal contract provides the agent with higher expected utility than his reservation level. These two tools are used to achieve separation among different types of firms such that firms with low potential do not have incentives to mimic contracts offered by high potential firms. Our findings imply that although loose monitoring and lavish compensation offered to employees may be symptoms of firms squandering scarce resources provided by investors, they can also arise as an optimal contracting arrangement.

Optimal Dynamic Relative Performance Evaluation

The theoretical prediction of a negative coe¢ cient on positively correlated peer performance that underlies much of the empirical literature on relative performance evaluation, is commonly obtained from the special case where variance-covariance matrix of the performance measures is exogenously restricted to be independent of the evaluee’s action. Using the dynamic approach of Holmstrom and Milgrom (1987), I study the properties of contracts that optimally condition an agent’s compensation both on his own performance and on how well he fares relative to a peer (group) when this restriction is not imposed. I show that if the covariance is non-zero, the optimal contract is linear in own and peer performance as well as the correlation between own and peer performance while, in line with the preponderance of the empirical evidence, in it’s simplest and perhaps most reasonable form the model predicts that the expected coe¢ cient on peer performance is exactly zero.

Management by the Numbers: A Formal Approach to Deriving Informational and Distributional Properties of “Un-managed” Earnings

We explore the theoretical relation between earnings and market returns as well as the properties of earnings frequency distributions under the assumption that managers use unbiased accounting information to sequentially decide on real options their firms have and report generated earnings truthfully, with the market pricing the firm based on those reported earnings. We generate benchmarks against which empirically observed earnings‐returns relations and aggregate earnings distributions can be evaluated. This parsimonious model shows a coherent set of results: reported losses are less persistent than reported gains, decision making diminishes the S‐shaped market response to earnings and earnings relate to returns asymmetrically in the way documented by Basu [1997]. Furthermore, the implied frequency distribution of aggregate earnings is neither symmetric nor necessarily single‐peaked. Instead, it may exhibit a kink at zero and look similar to the plots reported by Burgstahler and Dichev [1997]. However, within our model, none of these phenomena are due to reporting noise, bias, or some undesirable strategic managerial behavior. They are the natural consequences of using past earnings as the basis for value increasing managerial decision making that in turn generates the future earnings on which future decisions will be based.

Does It Pay to 'Be Like Mike'? Aspirational Peer Firms and Relative Performance Evaluation

We examine the manner and extent to which firms evaluate performance relative to aspirational peer firms. Guided by the predictions of an agency model, we find that CEO compensation increases in the correlation between own and aspirational peer firm performances. In addition, we define and test conditions where aggregate peer performance, which has been the primary focus of prior relative performance evaluation studies of competitive peers, is expected to have an association with CEO compensation. These conditions are supported by our empirical results. Finally, we document that our results are more pronounced when the firm-peer relationship is one-way and the peer firm is in a different industry and therefore is more aspirational.

Discussion of moral hazard and management control in just-in-time settings

Alles, Datar, and Lambert (henceforth ADL) set out to explore the management control and motivational aspects of Just-in-Time (JIT) inventory production systems within the agency theory paradigm. Specifically, ADL rely on the linear principal-agent model developed by Holmstrdm and Milgrom [1987; 1991]. The contribution of this type of analysis is determined jointly by the technical novelty of the results and their successful application to a specific setting studied. The following discussion is intended to aid in the evaluation of these aspects of ADLs paper. In section 2 I give a brief summary of the model followed by a discussion of the results in section 3. Section 4 addresses whether the model and the results capture recognizable features of the specific setting studied, i.e., issues of external validity. Finally, some concluding remarks are provided in section 5.