Value-Based Management

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1 Value-Based Management Handout Problem Set 3 Management Compensation - Bonus Banks Lehrstuhl für BWL Controlling Prof. Dr. Gunther Friedl for questions and comments: peter.schaefer@tum.de

2 Value-Based Management: Lecture 1 2

3 Question 6: Management compensation and bonus banks A company hires a new divisional manager as the head of one of its three business units. The compensation of the manager consists of an annual fixed salary of 90,000 Euro, an EVA-based annual bonus and yearly stock option grants. The bonus tied to the manager s business unit s EVA performance is supposed to be paid out in three equal tranches over 3 years. Thus, one third of the bonus earned is paid out in the same year, the rest is to be paid out in the next year and the year thereafter, including an interest on it (using the company s WACC of 10 %) to be consistent with the net present value rule. Assume the target bonus equals 100 % of base salary: If the manager achieves exactly the target EVA performance, he will earn a bonus of 90,000 Euro. Otherwise, the bonus is calculated proportional to the percentage of target achievement. Furthermore, assume a constant annual target EVA performance. To avoid retention problems and because negative payouts cannot be implemented in reality, a possibly negative bonus is not paid out immediately. Instead it is considered as interest-bearing and compensated with future bonus payments. The value of the bonus bank can be negative. Year EVA target achievement 75% - 100% 125% - 50% 100% Value-Based Management: Lecture 1 3

The bonus tied to the manager s business unit s EVA performance is supposed to be paid out in three equal tranches over 3 years.

4 Question 6: Management compensation and bonus banks Calculation of bonus payments Year Bonus earned Bonus 2007 Interests 2007 Bonus 2008 Interests 2008 Bonus 2009 Interests 2009 Bonus 2010 Interests 2010 Bonus 2011 Interests ,500 37,500 37,500 7,500 3,750-15,000-15,000-15,000-3,000-1,500 30,000 30,000 30,000 6,000 3,000 Handout Problem Set 3: Bonus Banks 4

2009 Interests 2009 Bonus 2010 Interests 2010 Bonus 2011 Interests 2011 37,500 37,500 37,500 7,500

5 Question 6: Management compensation and bonus banks Calculation of bonus payments Year Bonus earned 67,500-90, ,500-45,000 90,000 Calculated payout Real payout Beginning bonus bank Ending bank Handout Problem Set 3: Bonus Banks 5

67,500-90,000 112,500-45,000 90,000 Calculated payout Real payout

6 Question 6: Management compensation and bonus banks Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 6

7 Management compensation aims at balancing four sometimes conflicting fundamental objectives Alignment Choosing the right performance measures in order to align manager s and shareholders interests Retention Management compensation Wealth leverage Giving management sufficient incentives to work hard and to take the necessary risks in order to maximize shareholder value Shareholder cost Giving good managers sufficient total compensation to retain them even during periods of poor performance caused by market or industry factors Limiting the cost of management compensation to levels sufficient to maximize the wealth of current shareholders Handout Problem Set 3: Bonus Banks 7

order to maximize shareholder value Shareholder cost Giving good managers sufficient total compensation to retain them even during periods of poor performance caused by

8 Question 6: Management compensation and bonus banks Objectives of a bonus bank Handout Problem Set 3: Bonus Banks 8

9 Question 6: Management compensation and bonus banks First years problems Handout Problem Set 3: Bonus Banks 9

10 Bonus plan design: An example of a typical modern EVA bonus plan including a bonus bank (1/2) Bonus = target bonus + y ( EVA - expected EVA improvement) Bonus earned is credited to the bonus bank Typical payout rule: Excess EVA improvement Bonus earned Bonus banked 100% of bonus bank balance (if positive) up to the amount of the target bonus Target bonus Bonus paid + one third of bonus bank balance in excess of target bonus Bonus bank EVA interval Excess EVA improvement Handout Problem Set 3: Bonus Banks 10

Bonus banked 100% of bonus bank balance (if positive) up to the amount of the target bonus Target bonus Bonus paid + one third

11 Question 7: A bonus plan based on EVA improvements EVA improvements instead of absolute EVAs Handout Problem Set 3: Bonus Banks 11

12 Bonus plan design: An example of a typical modern EVA bonus plan including a bonus bank (2/2) Bonus = 100, % (DEVA - 5,000,000) Example of an EVA bonus plan Year EVA -30,000-15,000-20,000-5,000 EVA improvement 15,000-5,000 15,000 Expected EVA improvement 5,000 5,000 5,000 Excess EVA improvement 10,000-10,000 10,000 Target bonus Share of excess EVA improvement 2 % 2 % 2 % Bonus earned Bonus earned + bonus bank Bonus paid Ending bank Cumulative bonus earned = cumulative bonus paid + ending bonus bank Handout Problem Set 3: Bonus Banks 12

improvement 10,000-10,000 10,000 Target bonus 100 100 100 Share of excess EVA improvement 2 % 2 % 2 % Bonus earned 300-100 300 Bonus earned + bonus bank

13 Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 13

14 Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Year EVA ΔEVA Exp. ΔEVA Excess ΔEVA Target bonus Share of Excess ΔEVA 2 % 2 % 2 % Bonus earned Beginning bank (bonus earned + bonus bank + interests on bonus bank) Bonus paid Ending bank Handout Problem Set 3: Bonus Banks 14

15 Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 15

16 Question 8: Management compensation within the Metro Group Discussion of the bonus bank Handout Problem Set 3: Bonus Banks 16

17 Question 8: Management compensation within the Metro Group Example: Handout Problem Set 3: Bonus Banks 17

18 Question 8: Management compensation within the Metro Group Discussion of the bonus bank Handout Problem Set 3: Bonus Banks 18

19 ΔEVA target: Bonus earned = 10 % of ΔEVA ( target bonus = 100) Yearly payout from bonus bank: 40 % of bonus bank balance Question 8: Illustrative Example Year t EVA t ΔEVA t = EVA t EVA t-1 Bonus earned t = 0,1 ΔEVA t Payout from bonus earned t = Min{bonus earned t ; target bonus} if > 0; else: = = 0, = Min{210;100} Credit to bonus bank t = bonus earned t payout from bonus earned t Beginning bonus bank t = ending bonus bank t-1 + credit to bonus bank t Payout from bonus bank t = 0,4 beginning bonus bank t Bonus bank balance after payout t = beginning bonus bank t payout from bonus bank t Amount capped = amount in excess of a bonus bank balance of = = = 0, = Bonus bank balance after capping t Max. amount of bonus earned to be offset against capped amount =210-2 target bonus Amount offset against capped amount Ending bonus bank t Total payout in year t = Handout Problem Set 3: Bonus Banks 19

300-900 1.200 120 120-70 20 130-90 120 100 100 0 20 100 0 100 2.100 = 5.400 3.300 210 = 0,1 2.

20 Question 8: Management compensation within the Metro Group Components of management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 20

21 Question 8: Management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 21

22 Question 8: Management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 22

Value-Based Management

Value-Based Management Lecture 5: Calculating the Cost of Capital Prof. Dr. Gunther Friedl Lehrstuhl für Controlling Technische Universität München Email: gunther.friedl@tum.de Overview 1. Value Maximization