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CFA Level I · CFA Level I Exam · Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

A board's remuneration committee proposes that the CEO's bonus be based solely on one-year earnings per share growth. A shareholder advocate argues this design is flawed. The advocate's strongest argument is that the design most likely:

The design most likely encourages short-term risk taking that may reduce long-term shareholder value. A bonus tied only to one-year EPS growth rewards actions such as cutting investment or increasing leverage, which misaligns the CEO's incentives with long-term shareholders.

  1. Aencourages short-term risk taking that may reduce long-term shareholder valueCorrect
  2. Blowers the board's ability to retain independent directors
  3. Cmakes the bonus too difficult for the CEO to influence through decisions

Explanation

Pay tied to a single short-term accounting metric rewards actions that boost near-term EPS, such as cutting investment or taking excess risk, at the expense of long-term value. The CEO can influence EPS considerably, so the third option is wrong, and the director-retention claim is unrelated.

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