Case 5.0: Incentives in the Firm – Compensating the CEO

Let’s work through an incentive concept and problem. “Moral hazard” problems arise when someone – the “principal” – hires an agent to do something, but the agent has an incentive to do something else. For example, firm owners may want their management team to maximize profits, but maximizing profits is hard, time-consuming work that could interfere with the management team’s preference for playing golf. If top management simply receives a salary, the problem is aggravated because the managers may not be motivated to satisfy the owners, and the owners can’t easily monitor management activity to know if they’re really doing a good job. The problem is resolved in large part if the owners tie most or all of management compensation to firm profits, as income is often a pretty good motivator (although some golf nuts will still pause for a while over this one.) We can set up a scenario to explore this incentive issue further, and this problem will also help fix in our minds the difference between maximizing revenue and maximizing profit.

A small firm faces an inverse demand function of P = 100 - Q. Its total cost function is given by TC = .5Q².   (You should see right away that marginal revenue is thus MR = 100 – 2Q, and it also happens that marginal cost is just MC = Q. Both MR and MC are the first derivatives of total revenue and total cost. And a quick comment on MC: unlike some marginal cost functions we’ve seen, this one is not constant, because marginal cost is getting $1 higher with each additional unit of output.)

The Chief Executive Officer will manage the firm, choosing output and price. Currently, the CEO is negotiating an incentive-based contract with the shareholders of the company. The CEO has proposed that she get 20% of the total revenue brought in by the firm. The shareholders' representative has counter-offered that 10% of total revenue be given to the CEO. (Hint: basing compensation on revenue will motivate revenue maximization rather than profit maximization!)

1.    How much income will each plan generate for the CEO and for the shareholders, respectively? (Hint: since both plans create incentives for the CEO to maximize revenue rather than profit, you should not set MR = MC at this point. BIG hint: revenue is maximized when selling an additional unit won’t increase your revenue, or in math terms, when MR = 0.)

CEO’s proposal: she keeps 20% of TR.

Owners’ proposal: CEO keeps 10% of TR.

2.    Suppose you are asked to mediate in the negotiations. Can you propose an incentive-based compensation scheme for the CEO that both parties are likely to accept, assuming everyone would like to maximize their income?

Your proposal:

Demonstration that everyone is better off than under their own proposal and thus should accept your proposal:

3.    Now thinking even more shrewdly: what’s the maximum price you could charge for your consulting services and still leave everyone better off?

Please let us know if Facebook has any long-term debt on its balance sheet. Please give us some information about that long-term debt. You will have to look in the notes to the financial statements for this information. Also please calculate the times interest earned ratio for this corporation and let us know what this ratio indicates about its financial condition.

Part 2

What are unsecured notes? Why would they carry a relatively high interest rate? What are convertible securities? Why are they good for the investor and for the company? Why would they carry a relatively low interest rate? What does callable mean? What advantage does this feature give a company?

Responses to Instructor

Please check your thread for questions or comments from me and be sure to provide a comprehensive response, as requested.

Responses to Classmates

Please select one of the following bond issues and provide the journal entry when responding to your classmates this week:

1. Jan 1. ABC Corp issued $1,000,000 in bonds for a $75,000 discount.

2. Jan 1. ABC Corp issued $1,000,000 in bonds for a $50,000 premium.

Ayayai Corporation had the following stockholders’ equity accounts on January 1, 2020: Common Stock ($5 par) $500,000, Paid-in Capital in Excess of Par—Common Stock $200,000, and Retained Earnings $120,000. In 2020, the company had the following treasury stock transactions.

Ayayai Corporation uses the cost method of accounting for treasury stock. In 2020, the company reported net income of $30,000.

Prepare the stockholders’ equity section for Ayayai Corporation at December 31, 2020. (Enter the account name only and do not provide the descriptive information provided in the question.)

Stark Engineering Solutions Melbourneknew it had a problem with recruitment when it began to lose track of its job applicants’ Curriculum Vitae’s (CV’s or resume). It frequently called the same candidates for an interview twice and from time to time, sought to interview people it had already employed. HR staff would spend up to two hours looking for an individual CV’s for a given job.

The company had existed for around 4 years and had grown very rapidly. It had around 2000 employees but planned to expand this to 6000 over the next three years. The business, with 4 offices in major Australian cities, intended to take on approximately some extra 200 employees each quarter.

The Human Resources recruitment team had started with 2 members and had grown to 12 people across the four offices. The bigger it grew, the greater the chaos and confusion. The recruitment database was maintained in an MS Excel spreadsheet and was not coordinated between the 4 offices. They were receiving an average of1000 CV’s per month – via email or in the form of the hard copy sent by candidates or by recruitment firms – for an average of around 60 vacancies across all 4 offices at any given time.

An internal review demonstrated that the company had to standardise its recruitment processes and reduce duplication. The cost per hire needed to be cut and the overall quality of the talent hired by the business needed to rise.

The company felt that these improvements would help speed response times and promote a positive image. They could also help to improve the efficiency of the recruitment staff. Stark Engineering believed that the adoption of an online recruitment platform would improve the shortlisting process and boost candidate confidentiality. It could, in time, ensure a greater diversity of job applicants.

Source: Adapted from Instructor Resources-Nankervis, A., Compton, R., Baird, M. & Coffey, J. 2017. Human Resource Management, Strategy and Practice. (9th Ed.) Australia: Cengage Learning

Questions:

1. Explain the current problems facing the Stark Engineering recruitment team and how the benefits of using an online recruitment system could solve these issues for both the employer and the prospective candidates applying for the jobs.

this question is related to human resource management

A hurricane destroys Kirk’s boat in 2017. The boat is worth $40,000, and Kirk paid $30,000 for the boat two years ago. The boat is a personal use asset. Kirk’s AGI for 2020 is 40,000. Answer the following unrelated situations:

a. What is the casualty deduction that Kirk can take in 2017?

b. Assume that the boat was destroyed in 2020. What is the casualty deduction Kirk can take in 2020?

c. Assume that the insurance company pays Kirk $35,000 in 2017 to cover the loss of the boat. What is the casualty deduction Kirk can take in 2020?

Sako Company’s Audio Division produces a speaker that is used by manufacturers of various audio products. Sales and cost data on the speaker follow:

Sako Company has a Hi-Fi Division that could use this speaker in one of its products. The Hi-Fi Division will need 9,000 speakers per year. It has received a quote of $29 per speaker from another manufacturer. Sako Company evaluates division managers on the basis of divisional profits.

Required:

1. Assume that the Audio Division is now selling only 55,000 speakers per year to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

Transfer price=

c. If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 9,000 speakers from the Audio Division to the Hi-Fi Division?

d. From the standpoint of the entire company, should the transfer take place?

2. Assume that the Audio Division is selling all of the speakers it can produce to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

Transfer price=

c. If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 9,000 speakers from the Audio Division to the Hi-Fi Division?

d. From the standpoint of the entire company, should the transfer take place?

xercise 11A-1 Transfer Pricing Basics [LO11-5]

Sako Company’s Audio Division produces a speaker that is used by manufacturers of various audio products. Sales and cost data on the speaker follow:

Sako Company has a Hi-Fi Division that could use this speaker in one of its products. The Hi-Fi Division will need 9,000 speakers per year. It has received a quote of $31 per speaker from another manufacturer. Sako Company evaluates division managers on the basis of divisional profits.

Required:

1. Assume the Audio Division is now selling only 53,000 speakers per year to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

c. What is the range of acceptable transfer prices (if any) between the two divisions? If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 9,000 speakers from the Audio Division to the Hi-Fi Division?

d. From the standpoint of the entire company, should the transfer take place?

2. Assume the Audio Division is selling all of the speakers it can produce to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

c. What is the range of acceptable transfer prices (if any) between the two divisions? If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 9,000 speakers from the Audio Division to the Hi-Fi Division?

d. From the standpoint of the entire company, should the transfer take place?

1. Your client is a multinational corporation and is planning to manufacture certain products in a low tax international subsidiary that is 100% owned. The subsidiary would manufacture and sell the products to the US parent, and the parent would sell to unrelated customers.

a. Summarize the functions and risks that the company should consider in developing the transfer pricing documentation for this transaction.

b. What financial reporting and tax return matters should the company consider?

c. What information should you request from the client?

Part II: Wexler Wholesalers has an extensive line of sought after books, which has led to amassing an efficient distribution system to retailers. The following activities occurred during the first six months of 2020 with respect to its inventory:

1. Jan. 3, 2020: Wexler Wholesalers purchased 1,000 books from Jolly Publishers for $28 per book, terms 2/10,n30.

2. Jan. 7, 2020: Wexler Wholesalers returned 20 of the books purchased in transaction #1 for full credit.

3. Jan. 9, 2020: Wexler Wholesalers paid Jolly Publishers in full.

4. Feb. 1, 2020: Wexler Wholesalers purchased 1,200 books from Simon and Schuster for $34 each, terms 1/15,n30.

5. Feb. 2, 2020: Wexler Wholesalers phoned Simon and Schuster after receiving the order in transaction #4. The issue is the books were water damaged from sitting on a loading dock in the rain. Simon and Schuster offered Wexler Wholesalers a 75% allowance on the damaged books. Wexler Wholesalers accepted the offer.

6. Feb. 3, 2020: Wexler Wholesalers paid Simon and Schuster in full.

7. Feb. 27, 2020: Wexler Wholesalers sold inventory to Juniper Reading Nook costing $28 with a sales price of $60 each. A total of 180 books were sold, terms 3/15,n45.

8. Mar. 5, 2020: Wexler Wholesalers received payment from Juniper Retailers.

9. Jun. 3, 2020: Wexler Wholesalers sold 400 books to Read It Again Sam. The cost was $17 per book with a selling price of $55 each, terms 2/10,n30.

10. Jun. 8, 2020: Read It Again Sam returned 30 books to Wexler Wholesalers for full credit.

11. Jun. 9, 2020: Wexler Wholesalers received payment in full from Read It Again Sam.

12. Jun. 30, 2020: After being lost in the mail for months, Wexler Wholesalers received and paid $175 shipping costs associated with purchases from Simon and Schuster. Wexler Wholesalers is responsible for paying the shipping costs.

Part B: Prepare the income statement for Wexler Wholesalers for the first six months of the year through gross margin (gross profit). Part C: Wexler Wholesalers had opening inventory on January 1, 2020 of $11,500. What is the ending inventory as of June 30, 2020?