Incentives and Control
Week 2
Tutorial
Bouwens & Kroos (2019)
What is the decision that is focal in this study and how is the delegation of decision rights organized in this setting?
The focal decision in this study is the granting of loans. This decision lies at lower-level loan officers, however for
larger and riskier loans they need approval from higher-level.
What kind of customers are served in this bank and why is this relevant?
This bank serves private firms (small and medium sized enterprises). These firms have less verifiable information as
they don’t have annual reports, therefore more nonverifiable soft information is needed in the decision-making process.
What is the key problem that emerges when decision rights are organized as they are while serving the kind of
customers that they do?
Loan officers are incentivized to grant as much loans as possible, since it is part of their performance measure on
which their bonus is determined. Since loan officers are the ones to have repeated interactions with clients over time,
they collect the soft, nonverifiable information needed in the decision-making process. When approval from a higher-
level officer is needed the loan officer has to communicate this soft information, which they do with an optimistic bias,
as this positively influences the loan officer’s bonus. The key problem is that the soft information is collected by the
loan officers.
What are the two components of the riskiness of a loan? In addition, how do loan rates move (increase or decrease)
when the credit risk and total outstanding debt increase? Does this make sense to you?
The two components of the riskiness of a loan are the likelihood of default and whether there is collateral. When the
credit risk increases the interest rate goes up to compensate for the additional risk. However, if you loan more the loan
interest rate goes down, indicating a volume discount.
What is the main takeaway from Table 5? Is this consistent with the key problem that you discussed at point 3.
Loan officers, when they seek approval from higher-level, communicate in a positively biased manner as shown by the
more attractive terms and the worse loan performance of these loans.
What is the main takeaway from Table 6? Is this consistent with the key problem that you discussed at point 3.
In table 5 we saw that when higher-level officers rely on unaudited information that leads to more attractive interest
rates. However, if there is audited information the lower-level loan officers have more difficulty communicating about
the loan with an optimistic bias. As a result, these loans don’t get more attractive loan rates. As such we can conclude
that if the higher-level has to decide on the loans, loan officers are only able to get more positive terms when there is
no audited financial information. When there is audited financial information the effect is just 0. Which is consistent
with the key problem in point 3.
Wallace (1997)
What do we mean with the statement that ‘the use of traditional earnings in incentive compensation contracts may
lead to overinvestment?’
When using traditional earnings in incentive compensation any project that has an expected return higher than the cost
of debt will be accepted, since it will increase the absolute level of earnings. However, this investment could lead to a
reduction in shareholder wealth when the expected return is lower than the cost of capital (consisting of cost of debt
and cost of equity). Therefore, using traditional earnings in incentive compensation contract leads to overinvestment,
since projects that should’ve been rejected are accepted based on their comparison to cost of debt solely.
, Why would residual income (as performance measure in their incentive compensation contract) reduce these
overinvestment problems?
𝑅𝐼 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 ∗ 𝑐𝑎𝑝𝑖𝑡𝑎𝑙). As can be seen from the formula, both the cost
of debt and the cost of equity are considered in RI. As such, projects will only be accepted if the make up for both the
cost of debt and the cost of equity. Therefore, new projects face a higher hurdle, meaning that less investments
qualify. And therefore, the problem of overinvestment is reduced.
What is the main takeaway from Table 3? Explain these findings.
Table 3 shows the difference in manager’s investing decisions under a residual income-based compensation plan and a
traditional earnings-based compensation plan. We see that, following the adoption of a residual income-based
compensation plan, managers invest less. We also see that there are more asset dispositions. This is due to the firm-
value maximizing incentives the residual income plan gives: when there is no way to use assets more intensively
(increase asset turnover) to make up for the cost of equity (rather than solely the cost of debt) the asset is disposed
of. These old investments were made on the criteria of earnings but now the company uses RI and therefore projects
have to also make up for the cost of equity.
What is the main takeaway from Table 4? Explain these findings?
Table 4 shows the difference in manager’s share repurchases and dividends decisions under a residual income-based
compensation plan and a traditional earnings-based compensation plan. If the firm has excess cash it will hurt the RI
as it doesn’t generate extra money, therefore increasing the capital charge. As such with RI you want to keep excess
cash as small as possible. Therefore, managers get rid of the extra cash by repurchasing shares and paying out
dividends.
What is the main takeaway from Table 5 if you solely focus on asset turnover as the dependent variable? Explain these
findings?
Table 5 shows the difference in total asset turnover for firms with a residual income-based compensation plan and a
traditional earnings-based compensation plan. Following the adoption of a residual income-based compensation plan,
managers will invest less and therefore use their current assets more intensively. The old investments turn the RI
negative, but we can use these assets more intensively in order to try and make the profitable (So that they also make
up for the required rate of return from equity holders).
We also discussed underinvestment problems. What do we mean with underinvestment problems? Can residual
income also be used to address underinvestment problems?
When the incentive compensation contracts are based on ROI, managers will only invest in projects with the highest
ROI (that is higher than their current ROI). This leads to managers not investing in projects that add positively to the
total firm value, because it negatively impacts their performance measure. However, a residual income performance
measure will give managers incentives to not only accept projects with the highest ROI, but all projects with a NPV
higher than the cost of capital. As this will increase the RI and therefore the performance measure of these managers.
As such the underinvestment problem of ROI is addressed by RI. As we mentioned earlier, RI also addresses the
overinvestment problem of earnings.
Week 2
Tutorial
Bouwens & Kroos (2019)
What is the decision that is focal in this study and how is the delegation of decision rights organized in this setting?
The focal decision in this study is the granting of loans. This decision lies at lower-level loan officers, however for
larger and riskier loans they need approval from higher-level.
What kind of customers are served in this bank and why is this relevant?
This bank serves private firms (small and medium sized enterprises). These firms have less verifiable information as
they don’t have annual reports, therefore more nonverifiable soft information is needed in the decision-making process.
What is the key problem that emerges when decision rights are organized as they are while serving the kind of
customers that they do?
Loan officers are incentivized to grant as much loans as possible, since it is part of their performance measure on
which their bonus is determined. Since loan officers are the ones to have repeated interactions with clients over time,
they collect the soft, nonverifiable information needed in the decision-making process. When approval from a higher-
level officer is needed the loan officer has to communicate this soft information, which they do with an optimistic bias,
as this positively influences the loan officer’s bonus. The key problem is that the soft information is collected by the
loan officers.
What are the two components of the riskiness of a loan? In addition, how do loan rates move (increase or decrease)
when the credit risk and total outstanding debt increase? Does this make sense to you?
The two components of the riskiness of a loan are the likelihood of default and whether there is collateral. When the
credit risk increases the interest rate goes up to compensate for the additional risk. However, if you loan more the loan
interest rate goes down, indicating a volume discount.
What is the main takeaway from Table 5? Is this consistent with the key problem that you discussed at point 3.
Loan officers, when they seek approval from higher-level, communicate in a positively biased manner as shown by the
more attractive terms and the worse loan performance of these loans.
What is the main takeaway from Table 6? Is this consistent with the key problem that you discussed at point 3.
In table 5 we saw that when higher-level officers rely on unaudited information that leads to more attractive interest
rates. However, if there is audited information the lower-level loan officers have more difficulty communicating about
the loan with an optimistic bias. As a result, these loans don’t get more attractive loan rates. As such we can conclude
that if the higher-level has to decide on the loans, loan officers are only able to get more positive terms when there is
no audited financial information. When there is audited financial information the effect is just 0. Which is consistent
with the key problem in point 3.
Wallace (1997)
What do we mean with the statement that ‘the use of traditional earnings in incentive compensation contracts may
lead to overinvestment?’
When using traditional earnings in incentive compensation any project that has an expected return higher than the cost
of debt will be accepted, since it will increase the absolute level of earnings. However, this investment could lead to a
reduction in shareholder wealth when the expected return is lower than the cost of capital (consisting of cost of debt
and cost of equity). Therefore, using traditional earnings in incentive compensation contract leads to overinvestment,
since projects that should’ve been rejected are accepted based on their comparison to cost of debt solely.
, Why would residual income (as performance measure in their incentive compensation contract) reduce these
overinvestment problems?
𝑅𝐼 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 ∗ 𝑐𝑎𝑝𝑖𝑡𝑎𝑙). As can be seen from the formula, both the cost
of debt and the cost of equity are considered in RI. As such, projects will only be accepted if the make up for both the
cost of debt and the cost of equity. Therefore, new projects face a higher hurdle, meaning that less investments
qualify. And therefore, the problem of overinvestment is reduced.
What is the main takeaway from Table 3? Explain these findings.
Table 3 shows the difference in manager’s investing decisions under a residual income-based compensation plan and a
traditional earnings-based compensation plan. We see that, following the adoption of a residual income-based
compensation plan, managers invest less. We also see that there are more asset dispositions. This is due to the firm-
value maximizing incentives the residual income plan gives: when there is no way to use assets more intensively
(increase asset turnover) to make up for the cost of equity (rather than solely the cost of debt) the asset is disposed
of. These old investments were made on the criteria of earnings but now the company uses RI and therefore projects
have to also make up for the cost of equity.
What is the main takeaway from Table 4? Explain these findings?
Table 4 shows the difference in manager’s share repurchases and dividends decisions under a residual income-based
compensation plan and a traditional earnings-based compensation plan. If the firm has excess cash it will hurt the RI
as it doesn’t generate extra money, therefore increasing the capital charge. As such with RI you want to keep excess
cash as small as possible. Therefore, managers get rid of the extra cash by repurchasing shares and paying out
dividends.
What is the main takeaway from Table 5 if you solely focus on asset turnover as the dependent variable? Explain these
findings?
Table 5 shows the difference in total asset turnover for firms with a residual income-based compensation plan and a
traditional earnings-based compensation plan. Following the adoption of a residual income-based compensation plan,
managers will invest less and therefore use their current assets more intensively. The old investments turn the RI
negative, but we can use these assets more intensively in order to try and make the profitable (So that they also make
up for the required rate of return from equity holders).
We also discussed underinvestment problems. What do we mean with underinvestment problems? Can residual
income also be used to address underinvestment problems?
When the incentive compensation contracts are based on ROI, managers will only invest in projects with the highest
ROI (that is higher than their current ROI). This leads to managers not investing in projects that add positively to the
total firm value, because it negatively impacts their performance measure. However, a residual income performance
measure will give managers incentives to not only accept projects with the highest ROI, but all projects with a NPV
higher than the cost of capital. As this will increase the RI and therefore the performance measure of these managers.
As such the underinvestment problem of ROI is addressed by RI. As we mentioned earlier, RI also addresses the
overinvestment problem of earnings.
