1. Management Compensation and Business Valuation1 1

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

3. 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.

4. 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

5. 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

6. 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.

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

8. 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.

9. 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.

10. 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.

11. 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

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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

26. 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

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

28. 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

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

30. 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

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

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

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

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

35. End of Chapter 20 20