Question

            An organisation’s board decides that it needs to provide incentives for senior management to further the organisation’s goals. The board decides that the best way to do this is to provide bonuses based on increases in share value, measured at the end of each financial year. Bonuses are to be paid in shares which can be held by the managers or sold on the market.

What are the implications of introducing such a bonus system? Discuss in 120-150 words.

Answer 1

The implications of giving bonuses in shares to the managers as incentives on the basis of increase in share value are manifold. These are actually the accumulated earnings which instead of being distributed as dividends, they are given out in the form of free shares . These kind of incentives give the managers a stake in the performance of the organization and that encourages loyalty from their side. Distributing incentives in the form of shares tackles the problem faced by the organization of shortage of liquid funds. The impact of such a bonus could be an advantage from the view point of the company or the shareholder or may have certain disadvantages too.

The various advantages are as follows:

1. This is a boon to the company as in the event of a crisis that a company faces in the form of shortage of liquid funds wherein it is unable to pay cash dividends, it is able to satisfy the shareholders with the issue of shares in the form of bonus. Sometimes even if the company is not going through a crisis but chooses to retain its cash for the purpose of increasing its working capital or any other specific purpose then also it may go in for distribution of bonus in the form of shares and avoid payment of cash dividend.
2. Issue of shares as bonus is at times required for the company as it may be want to reduce its reserves for its own benefit and interest as failing to do that would encourage the competitors of the organization and also ends up being responsible for the creation of an unhealthy environment in the organization.
3. From the point of view of the senior management also it is beneficial as they do not have to pay taxes on the bonus shares whereas had they received their incentives in the form of cash dividend, they would have to pay tax on it and if they desire they can also convert these shares into cash by disposing it at a higher price and thereby making a profit too.

The disadvantages associated with this kind of bonus is that:

1. This kind of distribution of bonus in the form of shares encourages speculation which is not at all an ideal or desirable situation for the organization.
2. If the percentage at which the organization earns profit is not increased then it end up having an effect on rate of dividend falling and if in an organization the dividend rate fluctuates then the market prices of the shares will invariably go down.