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 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?

Answer 1

a)Let annual profit be Z & fastened part be F.

i) If Z> $200,000:
Bonus = F + (50% x $200,000) + [S% 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 on the far side $200,000 could end in a loss of $10,000, making the bonus theme unattractive, additionally as a result of for each $ increase in profit on the far side $200.000 the bonus will increase solely by five-hitter of the additional profit on the far side $200,000.

b) This profit-purchase worth linking could produce a distortion as a result of the manager could resort to not increase profits on the far side $200,000 to confirm the profit remains lower. The lower the profit the lower terms at that she will purchase the fimm

c) This contract does not align the goals of householders and therefore the manager, as a result of the contract structure can encourage the manager to stay profits lower so as to be able to get the corporate at a lower cost five years thus. this can be associate instance of the Principal-Agent downside wherever the agent (manager) takes choices to her own best interests, notwithstanding that goes to the impairment of the house owners.