Value-Based Management Handout Problem Set 3 Management Compensation - Bonus Banks Lehrstuhl für BWL Controlling Prof. Dr. Gunther Friedl Email for questions and comments: peter.schaefer@tum.de
Value-Based Management: Lecture 1 2
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 2008 2009 2010 2011 2012 EVA target achievement 75% - 100% 125% - 50% 100% Value-Based Management: Lecture 1 3
Question 6: Management compensation and bonus banks Calculation of bonus payments Year 2008 2009 2010 2011 2012 2013 2014 Bonus earned Bonus 2007 Interests 2007 Bonus 2008 Interests 2008 Bonus 2009 Interests 2009 Bonus 2010 Interests 2010 Bonus 2011 Interests 2011 37,500 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
Question 6: Management compensation and bonus banks Calculation of bonus payments Year 2008 2009 2010 2011 2012 2013 2014 Bonus earned 67,500-90,000 112,500-45,000 90,000 Calculated payout Real payout Beginning bonus bank Ending bank Handout Problem Set 3: Bonus Banks 5
Question 6: Management compensation and bonus banks Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 6
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
Question 6: Management compensation and bonus banks Objectives of a bonus bank Handout Problem Set 3: Bonus Banks 8
Question 6: Management compensation and bonus banks First years problems Handout Problem Set 3: Bonus Banks 9
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
Question 7: A bonus plan based on EVA improvements EVA improvements instead of absolute EVAs Handout Problem Set 3: Bonus Banks 11
Bonus plan design: An example of a typical modern EVA bonus plan including a bonus bank (2/2) Bonus = 100,000 + 2 % (DEVA - 5,000,000) Example of an EVA bonus plan Year 0 1 2 3 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 100 100 100 Share of excess EVA improvement 2 % 2 % 2 % Bonus earned 300-100 300 Bonus earned + bonus bank 300 33 300 Bonus paid 167 33 167 Ending bank 133 0 133 Cumulative bonus earned = cumulative bonus paid + ending bonus bank Handout Problem Set 3: Bonus Banks 12
Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 13
Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Year 0 1 2 3 EVA - 30.000-15.000-20.000-5.000 ΔEVA 15.000-5.000 15.000 Exp. ΔEVA 5.000 5.000 5.000 Excess ΔEVA 10.000-10.000 10.000 Target bonus 100 100 100 Share of Excess ΔEVA 2 % 2 % 2 % Bonus earned 300-100 300 Beginning bank (bonus earned + bonus bank + interests on bonus bank) Bonus paid Ending bank Handout Problem Set 3: Bonus Banks 14
Question 7: A bonus plan based on EVA improvements Consistency with the net present value rule Handout Problem Set 3: Bonus Banks 15
Question 8: Management compensation within the Metro Group Discussion of the bonus bank Handout Problem Set 3: Bonus Banks 16
Question 8: Management compensation within the Metro Group Example: Handout Problem Set 3: Bonus Banks 17
Question 8: Management compensation within the Metro Group Discussion of the bonus bank Handout Problem Set 3: Bonus Banks 18
ΔEVA target: + 1.000 Bonus earned = 10 % of ΔEVA ( target bonus = 100) Yearly payout from bonus bank: 40 % of bonus bank balance Question 8: Illustrative Example Year t 0 1 2 3 4 5 6 7 8 EVA t -200 1.000 2.200 1.500 1.700 3.000 2.100 3.300 5.400 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 1.200 1.200-700 200 1.300-900 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 2.100 100 = 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 100 20 20-70 0 30-90 20 20 32-51 -51-21 -111-80 8 13 0 0 0 0 0 12 19-51 -51-21 -111-80 110 = 210 100 30 = 80 + 110 12 = 0,4 30 18 = 30 12 0 0 0 0 0 11 0 0 Bonus bank balance after capping t 12 19-51 -51-21 -100-80 18 Max. amount of bonus earned to be offset against capped amount 0 0 0 0 0 0 0 10 =210-2 target bonus Amount offset against capped amount 0 0 0 0 0 0 0 10 Ending bonus bank t 12 19-51 -51-21 -100-80 8 Total payout in year t 108 113 0 20 100 0 100 112 = 100 + 12 Handout Problem Set 3: Bonus Banks 19
Question 8: Management compensation within the Metro Group Components of management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 20
Question 8: Management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 21
Question 8: Management compensation within the Metro Group Handout Problem Set 3: Bonus Banks 22