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Chapter 19

Chapter 19. Management Compensation and Business Valuation. Learning Objectives. Identify and explain the types of management compensation Identify the strategic role of management compensation and the different types of compensation used in practice

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Chapter 19

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  1. Chapter 19 Management Compensation and Business Valuation

  2. Learning Objectives • Identify and explain the types of management compensation • Identify the strategic role of management compensation and the different types of compensation used in practice • Explain the three characteristics of a bonus plan: the base for determining performance, the compensation pool from which the bonus is funded, and the bonus payment options

  3. Learning Objectives • Describe the role of tax planning and financial reporting in management compensation planning • Explain how management compensation plans are used in service firms and not-for-profit organizations • Apply the different methods for business evaluation and business valuation

  4. Learning Objective One Identify and explain the types of management compensation

  5. Management Compensation • Management compensation plans are an integral part of a strategic competitive advantage. • Recruiting • Motivating • Rewarding • Retaining effectivemanagement

  6. v.i.p. 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

  7. Learning Objective Two Identify the strategic role of management compensation and the different types of compensation used in practice

  8. 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

  9. 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

  10. 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.

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

  12. Learning Objective Three Explain the three characteristics of a bonus plan: the base for determining performance, the compensation pool from which the bonus is funded, and the bonus payment options

  13. Bonus 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. Key aspects of bonus pay plans:

  14. Bonus 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. Key aspects of bonus pay plans:

  15. Bonus Plans (c) payment options, that is, how the bonus is tobe 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. Key aspects of bonus pay plans:

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

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

  18. 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.

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

  20. Advantages and Disadvantages of Different Bonus Compensation Bases Unit Based (+) strong motivation for an effective manager -- the upside potential. (-) unmotivating for manager of economically weaker units. Motivation Right Decision (-) 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.

  21. Advantages and Disadvantages of Different Bonus Compensation Bases Firm-Wide (+) effort for the good of the overall firm is rewarded -- motivates teamwork and sharing of assets, etc., among units. 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.

  22. Advantages and Disadvantages of Different Bonus Compensation Bases Firm-Wide (+) 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. Fairness

  23. 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.

  24. Advantages and Disadvantages of Different Bonus Payment Options Current Bonus (+) strong motivation for current performance; stronger motivation than deferred plans. Motivation Right Decision (-) 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.

  25. Advantages and Disadvantages of Different Bonus Payment Options Deferred Bonus (+) strong motivation for current performance, but not as strong as for the current bonus plan, since the reward is delayed. Motivation Right Decision (-) 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.

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

  27. 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.

  28. Advantages and Disadvantages of Different Bonus Payment Options Performance Shares (+) unlimited upside potential is highly motivating. (-) delay in reward reduces motivation somewhat. Motivation Right Decision (+) 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.

  29. 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.

  30. Learning Objective Four Describe the role of tax planning and financial reporting in management compensation planning

  31. Tax and Financial Report Effectsof 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 expense deduction taxed 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 Deductioncapital gain

  32. Tax and Financial Report Effectsof Compensation Plans Financial State- Tax Effect ment Effect On the Firm On Manager Bonus Performance FootnoteDeferred DeferredShares Disclosure deduction tax Required Perks Certain Current Current Deferred Retirement expense deduction tax Plans Other Perks Current Current Never taxed expense deduction

  33. Learning Objective Five Explain how management compensation plans are used in service firms and not-for-profit organizations

  34. Example of a a Not-for-Profit Organization A good example of compensation-based responsibility accounting in not-for-profit organizations is the bonus arrangement for the manager of the Greensboro, North Carolina, Coliseum. The proposal included a $175,000 fee to the management company, a $125,000 salary to the director, and a bonus that would be available if revenues are higher than 80 percent of expenses. The current ratio of revenues to expenses is 75 percent. The cities goal was to reduce the deficit.

  35. Learning Objective Six Apply the different methods for business evaluation and business valuation

  36. Business Evaluation and Business Valuation • The principal approaches for evaluatinga firm’s performance are • Business Evaluation • Business Valuation

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

  38. The Business Evaluation Approach Primarily liquidity andprofitability ratios. • Balanced Scorecard • Financial Ratios • Economic Value Added

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

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

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

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

  43. The Business Valuation Approach Price-Earnings Ratio × Total Earnings • Market Value • Asset Valuation • Discounted Cash Flow • Multiples-Based

  44. End of Chapter Nineteen

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