The Owners of a small manufacturing concern have hired a manager to run the comp

Question

The Owners of a small manufacturing concern have hired a manager to run the company with the exception that he will buy the company after five years. The goal of the owners in making this higher is to find the appropriate manager that will increase profits substantially. Compensation of the new manager is a flat salary plus 50% of the first $200,000 of profit, and then 5% of the profit over $200,000. Purchase price for the company is set at 4 1/2 Times net earnings (profit), computed as average annual profitability (prior to calculation of the managers bonus) over the next five years.
a. Does the bonus structure for the manager to provide the manager with the appropriate incentive to increase profits beyond the first $200,000? Explain briefly.
b. Is it a good idea to link of the purchase price of the company to the earnings (profit) of the company. Given this linkage, what do you think the manager will try to do?
c. Does this contract align the incentives of the new manager with the (current) goals of the owners? The Owners of a small manufacturing concern have hired a manager to run the company with the exception that he will buy the company after five years. The goal of the owners in making this higher is to find the appropriate manager that will increase profits substantially. Compensation of the new manager is a flat salary plus 50% of the first $200,000 of profit, and then 5% of the profit over $200,000. Purchase price for the company is set at 4 1/2 Times net earnings (profit), computed as average annual profitability (prior to calculation of the managers bonus) over the next five years.
a. Does the bonus structure for the manager to provide the manager with the appropriate incentive to increase profits beyond the first $200,000? Explain briefly.
b. Is it a good idea to link of the purchase price of the company to the earnings (profit) of the company. Given this linkage, what do you think the manager will try to do?
c. Does this contract align the incentives of the new manager with the (current) goals of the owners?
a. Does the bonus structure for the manager to provide the manager with the appropriate incentive to increase profits beyond the first $200,000? Explain briefly.
b. Is it a good idea to link of the purchase price of the company to the earnings (profit) of the company. Given this linkage, what do you think the manager will try to do?
c. Does this contract align the incentives of the new manager with the (current) goals of the owners?

Explanation / Answer

a)

No. The bonus structure does not provide the manager with appropriate incentive to increase profits beyond $200,000. As we can see, the manager gets 50% of the first $200,000 profit but any profit over and above this amount will only gve him a return of 5%. This return of 5% is a drastic reduction form the initial 50%. Thus, the manager even if he increases profit beyond $200,000, the return that he gets on his effort to increase profits is little; and hence lacks appropriate incentive.

b)

It is not a good idea to link the purchase price of the company to the earnings (profit) of the company. This is because given the inappropriate incentive structure, the manager will try to maintain profits somewhere around $200,000 only. Thus, the purchase price of the company will be less than it could have been.

In this case, the manager will keep profits only around $200,000 and will intentionally not increase the business profits; so that he does not have to pay a very high purchase price.

c)

This contract does not  align the incentives of the new manager with the (current) goals of the owners because the current owners are looking for "the appropriate manager that will increase profits substantially." but the manager hired will not increase the profits substantially because that is directly related to the purchase price. Higher profits are what the owners want, but higher profits are also linked to higher purchase price for the manager(which he doesn not want). Thus, they have different interests.

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