Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-27 Alternative Compensation Plans (20 min)
1. On the negative side, stock option incentives tied to share prices
are influenced by the broad economic factors affecting the stock
market, many of which are uncontrollable by the managers. On
the plus, the use of stock options can effectively align the
can make to increase stock price will be rewarded.
EPS, ROI, and return on equity can be influenced by executives’
efforts and are therefore useful as motivational tools. The use of a
stock option plan often indicates that the firm’s strategy includes
plans for growth; executives expect that the firm’s growth will make
the options valuable in the coming years.
2. Plans based on EPS:
a. have a short-term focus, so that managers tend to
maximize short term earnings and not take actions which will in
the long-term benefit the company.
b. if the bonus incentive is very high, a focus on EPS can
performance.
20-11
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-28 Performance Evaluation and Risk Aversion (20 min)
1. A flat salary with a bonus based on number of processed
applications would be best. The flat salary reduces Lewis’ risk level
because it insulates her from the uncertainty of a fluctuating
2. Emphasis will be placed on volume with less attention given to the
3. Some possible measures include:
1. A measure based on the number of complaints or due to
20-12
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-29 Performance Evaluation and Risk Aversion (20 min)
1. Compensation for Amy should be the ROI-based bonus since she
is risk neutral. Amy would accept some risk to increase profit for
2. ROI is not a good evaluation standard for Amy because she has no
role in investing decisions. Return on sales would perhaps be a
3. a. Yes, this is a fair performance evaluation method. Since
Stiles Furniture is in a similar environment with the same capabilities
as NightTime, then Stiles will be affected by the same business and
competitive environment as NightTime.
The fact that Stiles uses a significantly different manufacturing
Amy will pass over projects which have ROIs that are high but not as
high as Amy is currently earning, then residual income is the answer.
A disadvantage of residual income is that it will provide an
unfair advantage (or disadvantage) to Amy if NightTime is large (or
small) relative to Stiles.
20-13
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-30 Bonus Compensation (10 min)
Ben’s return is 1,898,000/22,500,000 = 8.4% which is greater than
Note that stock price and customer service information is provided but not
used in the calculation of compensation, as the firm’s compensation is
based only on salary and a bonus awarded if the unit manager exceeds a
return on assets target. Also note that, while the unit manager’s get a
bonus based on achieving a unit-based performance target, the bonus pool
is based on the performance of the whole company.
20-31 Bonus Compensation Base and Pool (20 min)
This question is intended primarily for class discussion, and there are a
variety of possible responses. A suggested approach follows.
1. Alternative bonus compensation bases include the SBU responsibility
center measures (cost center, profit center, revenue center, and
investment center) as well as a potential wide variety of nonfinancial
measures.
2. The use of revenues will probably have an upward bias on bonuses,
at least at financial service companies in recent years. The reason is
that revenue has grown faster than profits for these firms in recent
not the base for the compensation. Shareholders are likely to be
pleased with increases in growth but more likely to be pleased with
increases in profits; so, in this case the compensation plan is not well-
20.31(continued -1)
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Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
aligned with that of shareholder interests. A compensation base that
3. The use of a firm-wide bonus pool likely makes sense in the financial
services industry, since the firms have highly integrated operations.
Firms in other industries, such as consumer products, might find a
4. The revenue-based method is not fair if you are considering the
shareholder point of view. The reason is noted in part 2 above;
shareholders are likely to place a higher value on earnings and cash
flow as opposed to revenue growth only. Considering the fairness of
Source: Liz Rappaport, Aaron Lucchetti, and Stephen Grocer, “Wall Street
Pay: A Record $144 Billion,” The Wall Street Journal, October 12, 2010, p.
C1; Joe Nocera, “Corzine Crashes Like It’s 2008,” The New York Times,
November 1, 2011, p. A21.
20-15
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-32 Compensation and Trust (15 min)
This question is intended primarily for class discussion or for a short written
project. The answers are likely to vary. I would have the class discussion
include the following points for each of the two parts of the requirements.
1. Many of the six points George makes can be summarized in the
concept that executive pay should be based on longer-term
measures than the annual profit and revenue-based approaches that
economic up-turns, as investors seek the safest (or most rewarding)
investments for their funds.
So the question should be, “Why an executive should be
rewarded for an increase in stock price that is due to these broad
economic changes?” Compensation based on longer-term and
(innovation, customer loyalty,…) of the company and have the
patience to see their efforts to improve these measures ultimately pay
off in financial performance.
2. Answers will vary on this point. I would point out that nonfinancial
measures such a customer service, quality, and innovation should be
rewarded in some way since they are often the means to long-term
competitive success and financial performance.
Another source of suggestions for improving executive compensation is
provided in a recent article by Alex Edmans. Edmans suggests the
compensation plan should focus on three key components:
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Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-32 (continued-1)
a. Don’t forget debt. Make sure that the executive compensation
plan includes in some way the valuation of the company’s debt.
This reflects the executives’ responsibility to creditors and also
research which suggests that including debt in executive
compensation will manage this risk and should lead to lower
interest cost for the company, a benefit to shareholders.
b. Require a long term before executives can cash in on stock
options – a really long time. For example, have them wait
that the executive maintains the required “skin in the game.”
The often chosen alternative of re-pricing stock options rewards
the executive for the falling stock price.
An important consideration, irrespective of the compensation plan chosen,
is to retain a compensation policy that attracts, retains, and effectively
motivates the best quality managers.
Source: Bill George, “Executive Pay: Rebuilding Trust in an Era of Rage,”
Bloomberg Businessweek, September 13, 2010, p. 56; Alex Edmans, “
How to Fix Executive Compensation,” The Wall Street Journal, February
27, 2012, pp. R1-2.
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Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-33 Compensation at Non-public Companies (15 min)
1. The advantage of equity based compensation is that it aligns
managers’ incentives with those of the shareholder – to increase
shareholder value.
2. A recent survey by Deloitte Development LLC found that nonpublic
firms are adding long-term incentive programs to their compensation
plans. The reason for the change to long-term incentives is to
achieve the desired alignment of managers’ incentives with those of
top management and the owners of the companies. Some
Reference: Elizabeth Drigotas, Greg Kopp, “Executive Compensation in
Private Companies: Strategies for Attracting, Retaining and Motivating Top
Talent,” Deloitte Development LLC, 2007.
20-18
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-34 Compensation in Tough Economic Times (15 min)
A survey by outplacement firm Challenger, Gray & Christmas [sic] reports
that 20% of companies are scaling back on perks and another 10% are
considering it. The perks most likely to go are travel related, since these
are the most costly. Other companies are cutting back on free cafeteria
service (Google), free masseuse service (a Los Angeles law firm),
company parties (Viacom), dinner and cab fare allowances (Goldman
Sachs), and company-owned jets (Alcatel-Lucent grounded its three
Gulfstream jets).
Other areas for potential reduction are bonuses, which have been
eliminated or deferred in many financial institutions at the end of 2008 and
have been limited at many organizations throughout 2009-2010.
Perks have been reduced in a number of ways. For example, companies
have in the past have paid executives more than the actual cost of travel
survey in 2010 showed this practice to be diminishing.
Other possible answers include reduction in health care coverage or
reduction in contributions to 401(k) plans. The difficulty here is that these
Matthew, Boyle, “Perks: A Moment of Silence,” Business Week, December
1, 2008 p 18; Dana Mattoli, “Perks Are Cut Amid Pushback on Pay,” The
Wall Street Journal, April 1, 2010, p. B4.
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Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
20-35 International Accounting Standards and Bonus Compensation
(20 min)
The move from GAAP to IFRS will likely have wide-ranging effects and
present a great deal of uncertainty to CFOs and others involved in the
development of management bonus compensation plans. Current bonus
contracts are written for GAAP and tax considerations are based on
U.S./GAAP-based taxable income. Compensation plans would have to be
revised to incorporate the expected changes in the financial statements as
a result of the change to IFRS. Some things to note in the discussion for
this question:
1. Many global companies are likely to benefit from the move to IFRS as
it would provide the company with a single set of standards which are
reconciliation of different accounting methods is reduced, and the
company is able to directly compare its financial reports from different
countries.
2. A related benefit for companies is that the comparability of managers’
performance evaluation reports (cost center, profit center, or
3. Those companies that had designed special in-company performance
measures using for example variable-costing principles or lean-
accounting principles, may have already achieved the desired level of
20-20
Education.