The bonus pool, mark to market and free cash flow: producer surplus and its vesting in the financial markets

Roger J. Bowden and Peter Posch

Applied Financial Economics, 2011, vol. 21, issue 24, 1843-1857

Abstract: Regulatory proposals that seek to limit or govern finance industry bonuses in the interests of systemic stability need to be grounded in the financial economics of producer surplus and its distribution. In this respect, existing treatments of economic agency in justifying large bonus awards are content to accept accounting Profit and Loss (P&L) numbers as a basis for the managerial bonus pool. We argue that managerial bonuses and shareholder dividends should be treated more symmetrically, and constrained by free cash flow criteria that capture producer surplus created by genuine managerial ability. Priority rules should apply, such that fair market value is a compensation for shareholder risk bearing and not a source of managerial surplus. The use of free cash flow conversion ratios neutralises the free option problem that has become a social irritant in public bailouts.

Date: 2011
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DOI: 10.1080/09603107.2011.595679

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