The owners of a small manufacturing company have hired a manager to run the comp

Question

The owners of a small manufacturing company have hired a manager to run the company with the expectation that he will buy the company after five years. The goal of the owners in making this hire is to find the appropriate manager that will increase profits substantially. Compensation of the new manager is a flat salary plus 50% of first $200,000 profit, and then 5% profit over $200,000. Purchase price for the company is set as 4.5 times net earnings profit, computed as average annual profitability prior to calculation of the managers bonus over the next five years.

(a) Does the bonus structure for the manager provide the manager with the appropriate incentive to increase profits beyond the first $200,000 ? Explain briefly.

(b) Is it a good idea to link the purchase price of the company to the earnings (profit) of the company. Given this linkage, what do you think the manager will try to do?

(c) Does this contract align the incentives of the new manager with the (current)goals of the owners?

Explanation / Answer

a) Lets say manager increases profit by $200,000. Then compensation of manager is flat salary+($100,000)

Purchase price of the company 4.5($40,000 - salary) = (180,000) - 4.5(salary)

If profit increases beyond $200,000, then compensation of manager is flat salary + ($100,000) + 0.05(amount over $200,000)

Purchase price of the company in this case 4.5(>=40,000) = (>=180,000)

There is incentive to increase profits beyond $200,000 because without that he won't be able to pay the purchase price out of what he earned in five years. He will have to pay (4.5/5) = 0.9 times the profits whereas will receive only 0.5 times $200,000 and 0.05 times excess amount.

b) Given the linkage manager will try not to increase the profits as he will have to pay (4.5/5) = 0.9 times the profits whereas will receive only 0.5 times $200,000 and 0.05 times excess amount.

C) no incentives of the new manager is not aligned with the goals of owners

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