Which of the following statements regarding compensation policies is FALSE?

Question

BlackTom AI · Accepted Answer

Increasing the pay‑for‑performance sensitivity increases, not reduces, a manager’s exposure to firm performance risk.

1. Relevant knowledge points and concepts
- Pay‑for‑performance sensitivity measures how much a manager’s pay changes with firm performance (e.g., stock returns).  
- Risk for a manager refers to the variability (variance) of his/her total compensation or wealth. Managers are typically risk‑averse and often hold undiversified human capital tied to the firm.  
- Equity grants (stock/options) increase the link between pay and firm value, aligning incentives but increasing income volatility.

2. Complete reasoning process step by step
- Increasing sensitivity means replacing fixed salary with variable pay or increasing the coefficient on performance in the compensation contract.  
- Variable pay depends on a stochastic performance variable (stock return or accounting performance), so its variance rises with the square of the sensitivity. Thus higher sensitivity raises the variance of total compensation.

3. Calculations and intermediate steps
- Let fixed salary = 100 (certainty), variable pay = b·P where E[P]=0, Var(P)=1. Total pay = 100 + b·P.  
- Var(total pay) = Var(b·P) = b^2 Var(P) = b^2.  
- If b increases from 0.5 to 1.0, Var(total pay) rises from 0.25 to 1.0. That is a fourfold increase in variance — more risk for the manager.

4. Why the correct answer is correct
- The statement claims increasing pay‑for‑performance sensitivity reduces managers’ risk. The analysis and calculation show the opposite: raising sensitivity increases pay volatility and thus managerial risk. Therefore that statement is false.

5. Why the other options are incorrect as false statements (i.e., why they are true)
- Stock and option grants give direct incentives to increase stock price because managers’ wealth rises with stock value — true.  
- Tying compensation to performance effectively gives managers ownership‑like payoffs (a claim on firm value) — true.  
- During the 1990s many firms did increase equity‑based compensation for executives — true.

6. Conclusion confirming the final answer
- The false statement is “Increasing the pay‑for‑performance sensitivity comes with the added benefit of reducing managers' risk.” This matches the provided correct answer.

Which of the following statements regarding compensation policies is FALSE?单项选择题

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