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Does the contract align the incentives of VP with owners?

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?

Solution Preview

See Excel attached.

A very curious problem. The answer is no, incentives to the new vice president counter the goals of the owners. The conclusion can be demonstrated by using three sample sale amounts:

Projected sale amount of company to new Vice President

Projected profit before incentive 150,000 450,000 750,000
Less 75% commission on first $150,000 112,500 112,500 ...

Solution Summary

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.

$2.19