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In: Finance

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

The owners of a small manufacturing company have hired a manager to run the company with the expectation that the new manager will buy the company after 3 years. Compensation of the new vice president is a flat salary of $100,000 plus 50% of the first $200,000 profit, then 10% of profit over $200,000. When the new manager purchases the company, he will be required to pay 5 times the average annual profitability of the 3 year period. 1. Plot the annual compensation of the VP as a function of annual profit. (Place profit on the horizontal axis and compensation on the vertical axis.) 2. Assume the company will be worth $10 million in 3 years. Plot the profit of buying the company as a function of annual profit. (Profit from purchase= Value – Price Paid) 3. Does this contract align the incentives of the new VP with the profitability goals of the current owners? 4. Redesign the contract to better align the incentives of the new VP with the profitability goals of the owners.

Solutions

Expert Solution

NOTE :- As the Quantitative details of the annual profits is not given in the question, we have done the calculation at various assumed profit levels.

1.

Profit levels Fixed Salary % of Profits Compensation
0 100000 0 100000
50000 100000 25000 125000
100000 100000 50000 150000
150000 100000 75000 175000
200000 100000 100000 200000
250000 100000 105000 205000
300000 100000 110000 210000
350000 100000 115000 215000

2. We have assumed various Annual average profit levels for calculation as actual profit details are not provided in the question.

Worth of the Company = $     1,00,00,000.00
Annual Average Profit Price Paid Profit on buying the company
$                                        -   $                             -   $      1,00,00,000.00
$                      3,00,000.00 $         15,00,000.00 $          85,00,000.00
$                      6,00,000.00 $         30,00,000.00 $          70,00,000.00
$                      9,00,000.00 $         45,00,000.00 $          55,00,000.00
$                    12,00,000.00 $         60,00,000.00 $          40,00,000.00
$                    15,00,000.00 $         75,00,000.00 $          25,00,000.00
$                    18,00,000.00 $         90,00,000.00 $          10,00,000.00
$                    20,00,000.00 $     1,00,00,000.00 $                              -  

3. As it is evident from the above graphs of the Annual profit and the Compensation to VP, with the increase in annual profit of the company, the growth rate in VP's compensation is decreasing. Also the Graph-2 shows that Profit from buying the company decreases with increase in the annual average profit of the company.

Thus, this contract does not align the incentives of new VP with the profitability goals of the old owners.

4. To align the incentives to the new VP with the profitability goals , the contract should be redesigned to give effect to the arrangement that gives increase in the return to the new VP with the increase in the Annual profitability of the company.

jeff jeffy answered 4 months ago
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