Management Compensation, Business Analysis, and Business Valuation

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Management Compensation, Business Analysis, and
Business Valuation
Chapter Nineteen
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Learning Objectives

• Identify and explain the types of management
  compensation
• Identify the strategic role of management
  compensation and the different types of
  compensation used in practice
• Explain the three characteristics of a bonus
  plan the base for determining performance, the
  compensation pool from which the bonus is funded,
  and the bonus payment options

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Learning Objectives (continued)

• Describe the role of tax planning and financial
  reporting in management compensation planning
• Explain how management compensation plans are
  used in service industries
• Apply different methods for business analysis and
  business valuation

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Management Compensation

• Recruiting, motivating, rewarding, and retaining
  effective managers is critical to the success of
  all firms
• Management compensation policies and procedures
  for compensating managers they include one or
  more of the following
• A fixed payment (called salary)
• A bonus (based on the achievement of performance
  goals for the period)
• Benefits (also referred to as perks, such as
  travel, membership in a fitness club, medical
  benefits, and other extras paid for by the firm)

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The Strategic Role of Management Compensation

• Top management should consider the specific
  strategic conditions facing the firm as a basic
  consideration in developing the compensation plan
  and making changes as strategic conditions change
• Top management can manage risk aversion
  effectively by carefully choosing the mix of
  salary and bonus in total compensation
• There is concern that executive pay is high
  compared to that of lower-level employees

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Management Compensation and the Sales Life Cycle
Sales Life Cycle Phase Salary
Bonus Benefits
Product Introduction
High Low
Low Growth Low
High Competitive Maturity
Competitive Competitive
Competitive Decline High
Low Competitive
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The Objectives of Management Compensation

• ... are consistent with the three objectives of
  management control presented in Chapter 17
• To motivate managers to exert a high level of
  effort to achieve the goals set by top management
  (bonuses)
• To provide the incentive for managers, acting
  autonomously, to make decisions consistent with
  the goals set by top management
• To develop fairly the rewards earned by managers
  for their effort and skill and the effectiveness
  of their decision-making

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Bonus Plans

• Bonus compensation is the fastest growing element
  of total compensation and is often the largest
  part
• Bonus plans can be categorized according to three
  aspects
• The base of compensation, that is, how the bonus
  pay is determined
• Compensation pools, that is, the source from
  which the bonus pay is funded
• Payment options, that is, how the bonus is to be
  awarded

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Base of Compensation

• Bonus compensation can be determined on the basis
  of
• Stock price
• Strategic performance measures (cost, revenue,
  profit, or investment SBUs)
• Performance measured by the balanced scorecard
  (CSFs)
• The choice of a base comes from a consideration
  of the compensation objectives of the firm
• Once the base is chosen, the firm must choose a
  method for calculating the amount of the bonus
  based on the actual level of performance relative
  to the target

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Bonus Compensation Pools

• Bonus compensation pools are either unit-based
  or firm-wide
• A unit-based pool is based on the performance of
  the managers unit the amount of the bonus for
  any one manager is independent of the performance
  of other managers
• A firm-wide pool contains the amount of bonus
  available to all managers bonuses depend on the
  firms performance as a whole

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Bonus Payment Options

• The four most common payment options are as
  follows
• Current bonus (cash and/or stock) based on
  current performancethe most common form
• Deferred bonus (cash and/or stock) earned
  currently but not paid for two or more years
• Stock options confer the right to purchase stock
  at some future date at a predetermined price
• Performance shares grant stock for achieving
  certain performance goals over two years or more

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Tax Planning and Financial Reporting

• In addition to achieving the three main
  objectives of compensation plans, firms attempt
  to choose plans that reduce taxes for both the
  firm and the manager
• Many perks are deductible by the firm but are not
  considered income to the manager (e.g., club
  memberships, company cars, and entertainment)
• Firms also attempt to design compensation plans
  to have a favorable effect on the firms
  financial reports

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Business Analysis

• Business analysis includes a set of tools used to
  evaluate the firms competitiveness and financial
  performance
• Three major sections to a business analysis
• Strategic and competitive analysis, including
  SWOT analysis and strategic positioning analysis
• Consideration of tools used to implement
  strategy, including the balanced scorecard (BSC)
• Ratios to measure the performance of individual
  SBU managers and of the entire company

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The Balanced Scorecard (BSC)

• The use of the BSC to evaluate a firm is similar
  to the use of CSFs in evaluating and compensating
  an individual manager
• A favorable evaluation results when the CSFs are
  superior to the benchmarks and to prior years
  performance
• For example, assume EasyKleen, a manufacturer of
  cleaning products, sets its benchmark at 90 of
  the best performance in the industry (see next
  slide for company data)

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Financial Performance
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Additional Performance Data
EasyKleen has three CSFs 1) Return on total
assets (financial performance) 2) Number of
quality defects (business processes) 3)
Number of training hours for plant workers
(human resources)
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BSC Performance Review
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Financial Ratio Analysis

• Ratio analysis uses financial statement data to
  evaluate performance, often in the areas of
  liquidity and profitability
• Liquidity refers to the firms ability to pay its
  current operating expenses and maturing debt (one
  year or less)
• Key liquidity measures
• Accounts receivable turnover
• Inventory turnover
• Current ratio
• Quick ratio
• Cash-flow ratios for operating cash flows and
  free cash flow

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Financial Ratio Analysis (continued)

• Key profitability ratios are
• Gross margin percent
• Return on assets
• Return on equity
• Earnings per share

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Financial Ratio Analysis Example
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Economic Value Added (EVA)

• EVA is a business units income after taxes and
  after deducting the cost of capital
• EVA approximates a firms economic profits
• EVA requires adjustments to financial accounting
  data to correct for accounting distortions
• EVA focuses managers attention on creating
  value for shareholders
• By earning higher profits than the firms cost of
  capital, the firm increases its internal
  resources available for dividends and/or to
  finance its continued growth

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EVA Example

• EVA for EasyKleen is determined as follows,
  with invested capital defined as total assets
  less current liabilities

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Business Valuation

• Business valuation examines the value of a
  company, to come up with a single dollar figure
  to represent the companys worth
• The value of a business can be approached in two
  different ways
• From the viewpoint of the owner, shareholder, or
  interested investor, i.e., the value of the
  firms shareholder equity
• From the viewpoint of a potential buyer what
  one would one pay to purchase the entire
  company--debt, equity, and assets

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Business Valuation (continued)

• Four approaches to measuring the value of
  shareholders equity
• The book value method is the quickest and easiest
  method and is equivalent to the value that
  appears on the balance sheet for stockholders
  equity
• The market value method is the market value of
  the firms common equity, directly from the
  current market value of the firms shares (market
  capitalization)
• The discounted cash flow method measures the
  firms equity value as the discounted present
  value of its estimated net cash flows
• The multiples-based approach uses a ratio of
  stock price to some financial measure to
  determine the value of the firms equity

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The Discounted Cash Flow (DCF) Method

• Four steps in the application of the DCF method
• Forecast free cash flows (operating cash flow
  less capital expenditures and less dividends
  paid) over a finite horizon (usually 5 to 10
  years)
• Forecast free cash flows beyond the finite
  horizon, using some simplifying assumption (e.g.,
  cash flows will continue on indefinitely)
• Discount free cash flows at the WACC, the firms
  weighted-average cost of capital
• Calculate the value of equity by adding the
  values calculated in step 3 to current
  nonoperating investments and then subtracting the
  market value of long-term debt

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Using Multiples for Valuation

• The multiples-based valuation uses the ratio of
  stock price to a key financial measure to
  determine a multiple that is used in valuation
• Key financial measures used in multiples-based
  valuation include
• Earnings
• Sales
• Cash Flow

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Enterprise Value (EV)

• Enterprise value (EV) is another measure of what
  the market says a company is worth, but this time
  in an acquisition
• EV is measured as the market value of the firms
  equity (market capitalization) plus debt, and
  less cash (cash is not available after the
  acquisition to pay off debt or for other uses)
• EV is used by investors and shareholders when an
  acquisition is being considered

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Chapter Summary

• Compensation plans are policies and procedures
  for compensating managers
• A salary is fixed payment
• A bonus is based on the achievement of
  performance goals for the period
• Benefits (also referred to as perks) include
  travel, membership in a fitness club, medical
  benefits, and other extras paid for by the firm
• In addition to achieving the three main
  objectives, firms attempt to choose compensation
  plans that reduce or avoid taxes for both the
  firm and the manager

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Chapter Summary (continued)

• A wide variety of bonus plans exists, but can be
  categorized according to three aspects
• The base of compensation, that is, how the bonus
  pay is determined (e.g., stock price, strategic
  performance measures (cost, revenue, profit, or
  investment SBU), or the balanced scorecard
  (CSFs))
• Compensation pools, that is, the source from
  which the bonus pay is funded (unit-based or
  firm-wide)
• Payment options, that is, how the bonus is to be
  awarded

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Chapter Summary (continued)

• In recent years, the use of different payment
  options for bonus compensation plans has greatly
  increased, but the four most common payment
  options are as follows
• Current bonus (cash and/or stock) based on
  current performance - most common form
• Deferred bonus (cash and/or stock) earned
  currently but not paid for two or more years
• Stock options confer the right to purchase stock
  at some future date at a predetermined price
• Performance shares grant stock for achieving
  certain performance goals over two years or more

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Chapter Summary (continued)

• Business analysis includes a set of tools used
  to evaluate the firms competitiveness and
  financial performance
• There are three major sections to a business
  analysis
• Strategic and competitive analysis, including
  SWOT analysis and strategic positioning analysis
• Consideration of tools used to implement
  strategy, including the balanced scorecard
• Ratios to measure the performance of individual
  SBU managers and of the entire company

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Chapter Summary (continued)

• Business valuation examines the value of a
  company, to come up with a single dollar
  figure of worth
• There are four approaches to equity valuation
• The book value method
• The market value method (market capitalization)
• The discounted cash flow method
• The multiples-based approach
• Enterprise value (EV) is a measure of what the
  market says a company is worth for acquisition
  purposes