The owners of a small manufacturing concern have hired a manager to run the company with the expectation that he will buy the company after five years. Compensation of the new vice president (manager) is a flat salary plus 75% of the first $150,000 of profit, and then 10% of profit over $150,000. Purchase price for the company is set as 4.5 times earnings(profit), computed as average annual profitability over the next five years. Does this contract align the incentives of the new vice president with the goals of the owners?
The solution projects the selling price for the new manager in three different scenarios to demonstrate the outcome given current compensation and incentives. After analysis, the answer is clear.