The owners of a small manufacturing concern have hired a manager to run the comp
ID: 1192198 • Letter: T
Question
The owners of a small manufacturing concern have hired a manager to
run the company with the expectation that (s)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
of profit, and then 5% of 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 purhcase 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) Let annual profit be Z & Fixed component be F.
(i) If Z > $200,000:
Bonus = F + (50% x $200,000) + [5% x (Z - $200,000)]
= F + $100,000 + 0.05Z - $10,000
= F + 0.05Z + $90,000
(ii) If Z <= $200,000
Bonus = F + (50% x $200,000)
= F + $100,000
Therefore, increasing the profit beyond $200,000 may result in a loss of $10,000, making the bonus scheme unattractive, also because for every $ increase in profit beyond $200,000 the bonus increases only by 5% of the extra profit beyond $200,000.
(b) This profit-purchase price linking may create a distortion because the manager may resort to not increase profits beyond $200,000 to ensure the profit remains lower. The lower the profit, the lower purchase price at which she can purchase the firm.
(c) This contract doesn't align the goals of owners and the manager, because the contract structure will encourage the manager to keep profits lower in order to be able to buy the company at a lower price 5 years hence. This is an instance of the Principal-Agent problem where the agent (manager) takes decisions to her own best interests, even if that goes to the detriment of the owners.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.