Question

Case 2.1 The Tex tech Company

When you hired Dan to manage your business, the TexTech Company, you agreed to pay him a bonus of 10% of profit at the end of each year. There are now two projects available for investment by TexTech, but it can only take on one of them: Project A will generate profits of $50,000 per year, and the detailed financial calculations show that it will increase the value of the company by $123,000. Project B will generate profits of $40,000 per year but will increase the company’s value by $125,000.

1. Which project is Dan likely to choose, and why?
2. Which project would you, the owner of the company, prefer?
3. By what means can the owners of the company encourage Dan to focus on owners’ wealth maximization?

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Answer 1

Which project is Dan likely to choose, and why?

Dan's variable payout is linked to the company's profit. Hence, Dan will prefer a project that leads to higher profitability. Since profit per year in case of project A = $ 50,000 > $ 40,000 = profit per year of project B, Dan will prefer project A.

Which project would you, the owner of the company, prefer?

The company or shareholders will prefer a project that leads to maximization of shareholders' value. Since incremental value creation by project A = $ 123,000 < $ 125,000 = incremental value creation by project B, the company will prefer project B.

By what means can the owners of the company encourage Dan to focus on owners’ wealth maximization?

Shareholders own the company but they don’t manage it. Hence, they elect Board of Directors comprising of executive, non executive directors and independent directors. The Board in turn, appoints top management and is supposed to ensure that managers act in the shareholders’ best interests.

Certain actions that can ensure alignment of interests are as follows:

1. Directly be involved in deciding the compensation packages of the key management professionals like Dan
2. Introducing performance based incentive structure. A part of the compensation should be linked to achievement of organizational goals such as company's economic value added, or company's share price increment etc.
3. Performance assessment of managers by the Board which should be empowered to take actions in cases where managers don't perform well or align themselves with the organisational goals
4. The message that management team members are not permanent and indispensable. They can be replaced and redeployed if need be.