Management Compensation and Business Valuation 1 1

Management Compensation Management compensation plans are an integral part of a strategic competitive advantage. Recruiting Motivating Rewarding Retaining effective management

Types of Management Compensation Salary--a fixed payment Bonus--based upon the achievement of performance goals Perks--special benefits for employees, such as travel, club membership, life insurance, stock options and other “extras” paid for by the firm v. i.p.

Compensation and Strategic Conditions Compensation plans differ as a firm’s products move from the growth phase through the maturity phase. Maturity Growth Decline Sales Introduction Time

Compensation and Strategic Conditions Product Sales Life Cycle Phase Salary Bonus Benefits Product Introduction High Low Low Growth Low High Competitive Maturity Competitive Competitive Competitive Decline High Low Competitive

Objectives of Management Compensation To motivate managers to exert a high level of effort to achieve the firm’s goals. To provide the right incentive for managers, acting autonomously, to make decisions that are consistent with the firm’s goals. To fairly determine the rewards earned by the managers for the their effort and skill, and for the effectiveness of their decision making.

Objectives of Management Compensation McDonald’s rewards managers for these critical success factors. Quality Service Cleanliness Value Earnings Growth in sales

Bonus Plans Key aspects of bonus pay plans: (a) the base of the compensation, this is, how the bonus pay is determined. The three most common bases are-- (1) stock price. (2) cost, revenue, profit, or investment-based performance. (3) balanced scorecard.

Bonus Plans Key aspects of bonus pay plans: (b) compensation pools, that is, the source from which the bonus pay is funded. The two compensation pools are-- (1) earnings in the manager’s own unit. (2) a firm-wide pool, based on total earnings of the firm.

Bonus Plans Key aspects of bonus pay plans: (c) payment options, that is, how the bonus is to be awarded. The two common options are-- (1) cash (2) stock (typically common shares) The cash or stock can either be awarded currently or deferred to future years. Also, the stock can either be awarded directly or granted in the form of stock options.

Advantages and Disadvantages of Different Bonus Compensation Bases Stock Price Motivation Right Decision (+/-) depends on whether stock and stock options are included in base and bonus (-) lack of controllability can be unmotivating (+) consistent with shareholders’ interests Fairness (-) lack of controllability

Advantages and Disadvantages of Different Bonus Compensation Bases Strategic Performance Measures Motivation Right Decision (+) strongly motivating if non-controllable factors are excluded. (+) generally a good measure of economic performance. (-) typically has a short-term focus. (-) if bonus is very high, creates an incentive for inaccurate reporting.

Advantages and Disadvantages of Different Bonus Compensation Bases Strategic Performance Measures Fairness (+) intuitive, clear, and easily understood. (-) measurement issues: difference in accounting conventions, cost allocation methods, financing methods.

Advantages and Disadvantages of Different Bonus Compensation Bases Balanced Scorecard: Critical Success Factors Motivation Right Decision (+) strongly motivating if non-controllable factors are excluded. (+) consistent with management’s strategy. (-) may be subject to inaccurate reporting. Fairness (+) if carefully defined and measured, CSFs are likely to be perceived as fair. (-) potential measurement issues, as above.

Advantages and Disadvantages of Different Bonus Compensation Bases Unit Based Motivation Right Decision (+) strong motivation for an effective manager -- the upside potential. (-) unmotivating for manager of economically weaker units. (-) provides the incentive for individual managers not to cooperate with and support others units, when needed for the good of the firm. Fairness (-) does not separate the performance of the unit from the manager’s performance.

Advantages and Disadvantages of Different Bonus Compensation Bases Firm-Wide Motivation Right Decision (+) helps to attract and retain good managers throughout the firm, even in economically weaker units. (-) not as strongly motivating as the unit-based pool. (+) effort for the good of the overall firm is rewarded -- motivates teamwork and sharing of assets, etc., among units.

Advantages and Disadvantages of Different Bonus Compensation Bases Firm-Wide Fairness (+) separate the performance of the manager from that of the unit. (+) can appear to be more fair to shareholders and others who are concerned that executive pay is too high.

Bonus Payment Options Current bonus, based on current performance. This is the most common form of the bonus. Deferred bonus, earned currently but not paid for two or more years. Stock options, the right to purchase stock at some future data at a pre-determined price. Performance shares, stock granted for achieving certain performance goals over a two or more year period.

Advantages and Disadvantages of Different Bonus Payment Options Current Bonus Motivation Right Decision (+) strong motivation for current performance; stronger motivation than deferred plans. (-) short-term focus. (-) risk-averse manager avoids risky but potentially beneficial projects. Fairness (+/-) depends on the clarity of the bonus arrangement and the consistency with which it is applied.

Advantages and Disadvantages of Different Bonus Payment Options Deferred Bonus Motivation Right Decision (+) strong motivation for current performance, but not as strong as for the current bonus plan, since the reward is delayed. (-) short-term focus. (-) risk-averse manager avoids risky but potentially beneficial projects. Fairness (+/-) depends on the clarity of the bonus arrangement and the consistency with which it is applied.

Advantages and Disadvantages of Different Bonus Payment Options Stock Options Motivation Right Decision (+) unlimited upside potential is highly motivating. (-) delay in reward reduces motivation somewhat. (+) incentive to consider longer-term issues. (+) provides better risk incentives than for current or deferred bonus plans. (+) consistent with shareholder interests.

Advantages and Disadvantages of Different Bonus Payment Options Stock Options Fairness (+/-) depends on the clarity of the bonus arrangement and the consistency with which it is applied. (-) uncontrollable factors affect stock price.

Advantages and Disadvantages of Different Bonus Payment Options Performance Shares Motivation Right Decision (+) unlimited upside potential is highly motivating. (-) delay in reward reduces motivation somewhat. (+) incentive to consider longer-term factors that affect stock price. (+) consistent with the firm’s strategy, when critical success factors are used. (+) consistent with shareholder interests, when earnings per share is used.

Advantages and Disadvantages of Different Bonus Payment Options Performance Shares Fairness (+/-) depends on the clarity of the bonus arrangement and the consistency with which it is applied.

Tax and Financial Report Effects of Compensation Plans Financial State- Tax Effect ment Effect On the Firm On Manager Salary Current Current Currently expense deduction taxed Bonus Current Current Current Currently Deferred Deferred Deferred Deferred expense deduction tax Stock Options-- Footnote Deduction Taxed as Nonqualified disclosure when ordinary Plans required exercised Income when exercised Stock Option-- As above No Taxed as Qualified Plans Deduction capital gain

Tax and Financial Report Effects of Compensation Plans Financial State- Tax Effect ment Effect On the Firm On Manager Bonus Performance Footnote Deferred Deferred Shares Disclosure deduction tax Required Perks Certain Current Current Deferred Retirement expense deduction tax Plans Other Perks Current Current Never taxed expense deduction

Business Valuation The principal approaches for evaluating a firm’s performance are Financial Analysis Valuation

The Financial Analysis Approach Benchmark comparisons on several critical success factors — quality, return on investment, employee development, etc. Balanced Scorecard Financial Ratios Economic Value Added

The Financial Analysis Approach Primarily liquidity and profitability ratios. Balanced Scorecard Financial Ratios Economic Value Added

The Financial Analysis Approach A business’s income after tax and after deducting the cost of invested capital. Balanced Scorecard Financial Ratios Economic Value Added

The Valuation Approach Number of shares outstanding × Share price Market Value Asset Valuation Discounted Cash Flow Earnings-Based

The Valuation Approach Net book value Gross book value Replacement cost Liquidation value Market Value Asset Valuation Discounted Cash Flow Earnings-Based

The Valuation Approach Present value of the firm’s net cash flows Market Value Asset Valuation Discounted Cash Flow Earnings-Based

The Valuation Approach Price-Earnings Ratio × Total Earnings Market Value Asset Valuation Discounted Cash Flow Earnings-Based

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