Level 3 Communications is a diversified communications and information services

Question

Level 3 Communications is a diversified communications and information services company, with over $1.5 billion in revenues in 2002. In order to recruit and reward talented senior employees, it implemented its Outperform Stock Option (OSO) program in April 1998. Level 3 rewards its senior executives with OSO options, whose value is based on Level 3's stock market performance relative to the performance of the S&P index. The option only has value if Level 3's stock outperforms the S&P 500, but it has no immediate value if its stock does worse than the S&P 500. a) Use the principles of incentive contract design to analyze the main advantages of the OSO program. b) Only a few firms have adopted similar programs. Discuss why a firm might be reluctant to use OSO options.

Explanation / Answer

a) When a company offers salary incentives to an employee, they are ensuring that the employee will produce the optimal output. They are thereby, able to increase their marginal product of capital by receiving more output per unit of capital spent. b) Although this kind of compensation typically motivates employees to perform better, it also has several potential pitfalls that come with it. - It often limits the number of employees available to the firm. Many employees are uncomfortable being paid based the companies stock price because it's often out of their control. All it takes is for one employee to screw something up and drive down the companies stock. The stock price is based on the company as a whole, not an individual employees effort. - It encourages unethical behavior such as earnings management. Oftentimes, when a company's administration is paid with stock options, they will attempt to understate profits in periods when their stock price goes up, and then use those profits that they didn't include last period to overstate profits in periods when their stock ay fall.

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