The owner\'s of a small manufacturing concern have hired a manager to run the co

Question

The owner's of a small manufacturing concern have hired a manager to run the company with the expectation that he will buy the company after 5 years. Compensation of the new vice president is a flat salary pluss 75% of the first $150,000 profit, then 10% of profit over $150,000. Purchase price for the company is set at 4.5 times earnings (profit), computed as average annual profitability over the next five years.

Q1- Does this contract align the incentives of the new vice president with the profitability goals of the owners?

Q2- Redesign the contract to better align the incentives of the new vice president with the profitability goals of the owners.

Explanation / Answer

a. No, both these incentives are not aligned. If the VP keeps $0.75 of each dollar earned up to $150,000, (a total of $112,500) then we will be motivated up to that point only. Just $0.10 of each dollar earned after $150K is a decreasing marginal benefit and increasing marginal effort for him. Therefore, he has only a little incentive to earn over and above $150,000.Morover, every dollar he earns will increase the price that he eventually needs to pay for the company by $4.50, which is a disincentive for him to increase company’s profitability.

b.) One of the ways to resign this contract would be to set a purchase price at the beginning of this contract. This would motivate the VP to increase the profits of the company as much as possible. This is because in this scenario his marginal wealth of 10% above 150k are not offset by the tremendous increases in purchase price. Moreover, this also motivates him to make more profits as he will eventually own the company after the 5 years.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.