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20-1 The key objective of the firm is to develop management compensation plans that support the
firms strategic objectives:
1. To motivate managers to exert a high level of effort to achieve the firms goal.
2. To provide the right incentive for managers, acting autonomously, to make decisions that
are consistent with the firms goals.
3. To fairly determine the rewards earned by the manager for their effort and skill, and for
the effectiveness of their decision making.

20-2 Management compensation includes one or more of the following: salary, bonus, and benefits or
perquisites (perks).
Salary is a fixed payment, while a bonus is based upon the achievement of performance
goals for the period. Perks include special services and benefits for the employee, such as travel,
membership in a fitness club, life insurance, medical benefits, tickets to entertainment events,
and other extras paid for by the firm.

20-3 Risk aversion is the tendency to prefer decisions with assured outcomes over those with uncertain
outcomes. It is a relatively common decision-making characteristic of managers. A risk-
averse manager is biased against decisions that have an uncertain outcome, even if the expected
outcome is favorable. The risk-aversemanager prefers choices with certain outcomes to choices
with more favorable outcomes which are not certain. The effect is that certain decisions that
would be preferred by top management might be rejected by the manager because of the
managers risk aversion. Compensation plans can be adapted to deal with risk aversion by, for
example, making sure that a significant part of total compensation is salary, which is not subject
to risk. Other means include rewarding the manager for achievement of critical success factors,
such as an investment in a promising new research area, in addition to the financial measures
which compensation is typically based upon (such as earnings or earnings per share).

20-4 Management compensation plans designed to motivate managers can have undesired unethical
effects. The presence of very strong motivation due to a compensation plan, without
compensating accounting controls designed to detect and prevent fraud, can lead to unethical
behavior. The best method to reduce the potential for unethical behavior is explained in chapter
1: adopting and adhering to the Institute of Management Accountants Code of Ethics.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation
20-5 From a financial reporting standpoint, the most desirable form of compensation is deferred
payment plans, which delay the expense on the income statement.

20-6 From the standpoint of taxes paid by the individual manager, the least desirable forms of
compensation are ones which have immediate tax consequences. These include salary increases
and cash bonuses. The most desirable form of compensation is perks, which are not shown as
income (subject to limitations set out by the Internal Revenue Service for certain types of perks).
The most desirable form of compensation from the standpoint of the firm is also perks as well as
salaries or cash bonuses, since they are deductible immediately for tax purposes.

Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-7 The three bases for incentive bonus plans are stock price, a responsibility accounting measure such
as the units profit or ROI, and the balanced scorecard. See Exhibit below:
Advantages and Disadvantages of Bonus Compensation Bases
Bonus Base Motivation Right Decision Fairness
Stock Price (+/-) depends on (+) consistent with (-) lack of
whether stock and shareholders controllability
stock options are interests
included in base pay
and/or bonus
(-) lack of
controllability can be
(+) aligns
compensation with
shareholder interests
Strategic (+) strongly motivating (+) generally a good (+) intuitive, clear,
Performance if non-controllable measure of and easily
Measures (cost, factors are excluded economic understood
revenue, profit, performance (-) measurement
and investment (-) typically has only issues: differences
center) a short term focus in accounting
(-) if bonus is very conventions, cost
high, can cause allocation methods,
inaccurate reporting financing
Balanced (+) strongly (+) consistent with (+) if carefully
Scorecard: motivating if non- managements defined and
Critical Success controllable factors strategy measured, CSFs
Factors are excluded (-) may be subject to are likely to be
(+) aligns inaccurate reporting, perceived as fair
management interest as for responsibility (-) potential
with long-term accounting measurement
shareholder interests measures issues, as for
Key: (+) means the base has a positive effect on the objective; (-)means the base has a negative effect
on the objective.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-8 The six financial ratios used in the evaluation of liquidity are:
The first and second ratios are the accounts receivable and inventory turnover ratios
which measure the firms ability to manage two important elements of current assets - accounts
receivable and inventory. The lower the balance in these accounts relative to sales, the less cash
will be tied up in these accounts, and therefore the more cash the firm will have to pay its current
obligations. The greater these ratios, the better, and the higher the evaluation of the firms

A third measure is the current ratio, current assets divided by current liabilities, which
measure the firms short-term ability to pay operating expenses.
The fourth measure, the quick ratio, is a very short-term measure of liquidity, since the
relatively less liquid inventory is not included.
The fifth measure, the cash flow ratio (cash flow from operations to current liabilities)
The sixth measure, free cash flow ratio (net free cash flow divided by current liabilities)
measures the effect of the firms cash flows on liquidity.

20-9 The two types of bonus pools are unit-based and firm-wide. The unit-based is determined from
earnings in the unit only, while the firm-wide pool is determined from the earnings of the
aggregate firm. See below:
Advantages and Disadvantages of Different Bonus Pools
Motivation Right Decision Fairness
Unit-Based (+) strong (-) provides the (-) does not
motivation for a incentive for separate the
successful individual managers performance of the
manager the not to cooperate unit from the
upside potential with and support managers
(-) unmotivating for other units, when performance
manager of needed for the
economically good of the firm
weaker units
Firm-Wide (+) to attract (+) effort for the (+) separates the
and retain good good of the overall performance of the
managers firm is rewarded - manager from that
throughout the firm, motivates teamwork of the unit
even in and sharing of (+) can appear to
economically assets, etc, among be more fair to
weaker units units shareholders and
(-) not as strong a others who are
motivation for the concerned that
individual manager executive pay is too
as the unit-based high
Key: (+) means the pool has a positive effect on the objective;

Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

(-) means the pool has a negative effect on the objective.

20-10 The four types of bonus payment options are current cash bonus, deferred bonus, stock options,
and performance shares. See Exhibit below:

Advantages and Disadvantages of Different Bonus Payment Options

Motivation Right Decision Fairness
Current Bonus (+) strong (-) short term focus (+/-)depends on
motivation for (-) risk averse manager the clarity of the
current avoids risky but bonus
performance; potentially beneficial arrangement and
stronger motivation projects the consistency
than for deferred with which it is
plans applied
Deferred Bonus (+) strong (-) as above` (+/-) as above
motivation for
performance, but
not as strong as for
the current bonus
plan, since the
reward is delayed
Stock Options (+) unlimited upside (+) incentive to consider (+/-) as above,
potential is highly longer term issues plus
motivating (+) provides better risk
(-) delay in reward incentives than for (-) uncontrollable
reduces motivation current or deferred factors affect stock
somewhat bonus plans price
(+) consistent with
shareholder interests
Performance as for stock option (+) incentive to (+/-) depends on
Shares consider longer term the clarity of the
issues bonus
(+) consistent with the arrangement and
firms strategy, when the consistency
critical success factors with which it is
are used applied
(+) consistent with
shareholder interests,
when earnings per
share is used
Key: (+) means the payment option has a positive effect on the objective; (-)means the payment
option has a negative effect on the objective.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-11 This question is intended for class discussion. There are a number of possible views on this
question. The goal of the discussion should not be to determine the equity of a certain level of
executive pay, but rather to show the ethical issue as a potentially important factor in developing
management compensation plans. The firm and the management accountant who is developing
the compensation plan should be sensitive to the concerns of shareholders and other
constituents of the firm.
20-12 The five methods discussed in the chapter for directly measuring the value of a firm: book value
of equity, market value of equity (market capitalization), the discounted cash flow
method, multiples-based valuation, and enterprise value.
The book value method takes the amount of equity from the balance
The market value method is the most simple and direct. The value of the firm is
determined from the number of outstanding shares multiplied by the current market price of the
The discounted cash flow (DCF) method develops the value of the firm as the discounted
present value of the firms net free cash flows. It has the advantage that it considers the time
value of money and the cash flows from operations, and it is not subject to the same effects of
different accounting policies as are the asset valuation method and the indirect method. This is
the most commonly used method when the share price is not available or is unreliable.

The multiples-based method computes value as the product of expected annual sales,
earnings, or cash flow times a multiplier. There is a different multiplier for each accounting
measure: sales, earnings, or cash flow. When the earnings multiple is used, the multiplier is often
estimated from the price-to- earnings ratios of the stocks of comparable publicly-held firms. The
earnings multiplier has important limitations. It is based on accounting earnings, and is therefore
subject to the limitations of accounting earnings. The advantage is that the earnings multiplier is
easy to apply.
The enterprise value method takes market capitalization, adds debt and subtracts cash to
arrive at an amount that would approximate the price of the whole firm in an acquisition.
In practice, it is common for the management accountant or analyst to use two or more
of the valuation techniques and to evaluate the assumption in each in order to arrive at an overall
valuation assessment.

20-13 Bonuses are the fastest growing part of total compensation. The growth of interest in bonus plans
is likely the result of firms increasing competition for the very best executive talent. Also,
shareholders prefer bonus plans to other forms of compensation, since, when the managers
perform well the shareholders benefit as well as the managers.

Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-14 The goal of strategic cost management is the success of the firm in maintaining competitive
advantage, so it is important to evaluate the overall performance of the firm, as well as that of
each of the individual managers.
20-15 The firms strategy changes as its product(s) move through the different phases of the sales life
cycle - product introduction, growth, maturity, and decline (the sales life cycle is covered in
Chapter 13). As a firms product moves from the growth phase to the maturity phase, the firms
strategy also moves from product differentiation to cost leadership. When this happens, the
compensation plan should change in response to the new strategy. The exhibit below illustrates
how the mix of the three types of compensation (salary, bonus, perks) might change as the firm
and its products move through different phases of the sales life cycle.

Compensation Plans Tailored for Different Strategic Conditions

Product Sales Life Compensation Plan
Cycle Phase
Salary Bonus Benefits
First: Product High Low Low
Second: Growth Low High Competitive
Third: Maturity Competitive Competitive Competitive
Fourth: Decline High Low Competitive
Key to Exhibit: Competitive lies between low and high.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation


Inventory Turnover = _Cost of Good Sold_
Average Inventory
= ______$400,000______
($50,000 + $70,000) / 2
= _$400,000_
= 6.67
Percent Achievement = 6.67 / 6
= 111%

Market Value of Equity = Stock Price x # Shares Outstanding
=$25 x 100,000
Economic Value Added = EVA-based Net Income
Cost of Capital x EVA-based Invested Capital
=$200,000 (10% x $750,000)
DCF Value = PV of cash flows + marketable securities market value of debt
=$400,000 + $150,000 $250,000

Multiples-Based Valuation = Earnings Multiplier x Earnings
=7 x $250,000
Gross Profit Margin = _Gross Profit_
Net Sales
= _$250,000_
= 16.67%
Percentage Achievement = _16.67%_
= 167%
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation


20-22 Compensation, Strategy, and Market Value (20 min)

Jackson Supply is experiencing the anomaly of achieving its strategic goals (customer service)
while the stock price is falling relative to competitors. Two questions arise:
1.Is the firm properly measuring customer service? Perhaps more direct and effective
measures are needed.
2.It may be that investors do not value the firms customer service goals. The investors
may be looking for cost reduction, for production diversification and innovation, supply-
chain management innovation, or other strategic initiatives. What are competitors doing? The
firm might benefit from consulting with industry experts or financial analysts that specialize in
medical supply. In the end, Jackson Supply must realize that its ultimate strategy must be to
satisfy shareholders, and the specific goals that are chosen, such as customer service, must be
linked to that strategy. Success is judged by investors and not by top management.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-23 Performance Evaluation and Risk Aversion (20 min)

1.A flat salary with a bonus based on number of processed applications would be best. The flat
salary reduces Lewis risk level because it insulates her from the uncertainty of a fluctuating
environment; the salary portion of her compensation is risk free. This allows her to devote herself
to the job without worrying that a sudden crush (or absence) of applications will cause her to
have a poor performance report.

2.Emphasis will be placed on volume with less attention given to the quality of the processing.
Jill should be giving attention to both the quantity and accuracy of the work done.

3.Some possible measures include:

1.A measure based on the number of complaints or due to errors in the applications.
2.Surveys of applicants that inquire about the correctness of the data.
3.Random checks of completed applications for correctness.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-24 Performance Evaluation and Risk Aversion (20 min)

1.Compensation for Amy should be the ROI-based bonus since she is risk neutral. Amy would
accept some risk to increase profit for Heartwood and thereby increase her compensation.

2.ROI is not a good evaluation standard for Amy because she has no role in investing decisions.
Return on sales would perhaps be a better measure. This would emphasize sales margins as
opposed to return on investment. Also, controllable contribution could be used as a base for
performance measurement.

3.a. Yes, this is a fair performance evaluation method. Since Stiles Furniture is in a similar
environment with the same capabilities as NightTime, then Stiles will be affected by the same
business and competitive environment as NightTime.
The fact that Stiles uses a significantly different manufacturing process is irrelevant
because the two companies have the same capabilities. If Stiles is more successful with an
alternative strategy, then Amy should be held responsible for not altering her strategy as well.
b. The advantage to residual income is that it will motivate Amy to invest in all projects
which earn over a threshold return. If Amys division is earning a high ROI, and management is
concerned that Amy will pass over projects which have ROIs that are high but not as high as Amy
is currently earning, then residual income is the answer.
A disadvantage of residual income is that it will provide an unfair advantage (or
disadvantage) to Amy if NightTime is large (or small) relative to Stiles.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-25 Evaluating an Incentive Pay Plan; Strategy (15 min)

Unless Fox is rewarded significantly by the boat manufacturers for volume of sales, the current
incentive plan is likely to reduce profits by increasing sales at the expense of profit margins. Sales
representatives incentives are to sell as many boats as possible, and since reducing the price will
help them to achieve this goal, they are likely to sell many boats at low prices. A better approach
would be to compensate the sales representatives on the basis of the contribution margin for
each boat sold. This would have the effect of rewarding the salespeople for keeping prices and
margins high. The salespeople would then have the same incentive as Fox - the overall
profitability of the dealership.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-26 Alternative Compensation Plans (20 min)

1. On the negative side, stock option incentives tied to share prices are influenced by the broad
economic factors affecting the stock market, many of which are uncontrollable by the managers.
On the plus, the use of stock options can effectively align the managers incentives and efforts
with those of the shareholders, who value the increase in stock price. Whatever efforts the
manger can make to increase stock price will be rewarded. Of particular importance, since the
change in the financial reporting standards in 2005 to require companies to expense stock
options, many companies have sharply reduced the number of stock options granted to
executives to avoid the expense on the income statement.
EPS, ROI, and return on equity can be influenced by executives efforts and are therefore useful
as motivational tools. The use of a stock option plan often indicates that the firms strategy
includes plans for rapid growth; executives expect that the firms growth will make the options
valuable in the coming years.

2.Plans based on EPS:

a.have a short-term focus, so that managers tend to maximize short term earnings and
not take actions which will in the long-term benefit the company.
b.if the bonus incentive is very high, a focus on EPS can cause pressure for managers to
act unethically in manipulating earnings by misstating the accounts or by using improper revenue
or expense recognition policies.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-27 Business Analysis (30 min)

The financial ratios are shown below
Financial Ratios 2010 2009 Industry
Liquidity Ratios
Accounts Receivable Turnover 11.20 13.09 11.10
Inventory Turnover 13.33 14.86 11.30
Current Ratio 4.73 2.30 2.80
Quick Ratio 3.73 1.60 2.00
Cash Flow Ratios
Cash Flow from Operations 1.05 1.52 1.20
Free Cash Flow 0.85 1.52 1.10
Profitability Ratios
Gross Margin Percentage 28.6% 27.8% 30%
Return on Assets (Net Book
Value) 13.5% 15.9% 20%
Return on Equity 26.0% 32.2% 30%
Earnings per Share $0.167 $0.183 -

The turnover ratios and the return on assets and return on equity ratios for 2010 use the
average of the 2010 and 2009 balances in the denominator.

The financial ratios for Somerfeld Company show good performance on liquidity, with all four
ratios better than the industry average. However, the receivables and inventory turnover ratios
have fallen in 2010, and the receivables turnover ratio is now very close to the industry average
for 2010. Management should check to make sure that credit granting and collections
procedures are being maintained properly, and that the trend of declining turnover ratios does
not continue.

The cash flow ratios have declined and are both less than the industry average in 2010; the
reasons behind the decline are a decline in net income, the increase in receivables and
inventory, and (for the free cash flow ratio), the dividend payment of $40,000.

The profitability ratios are unfavorable. The gross margin percentage is less than the industry
average, as is the return on assets ratio. The gross margin ratio has not changed significantly
from 2009 to 2010, showing that the company has been able to control costs of sales as sales
have fallen. However, return on assets and return on equity have fallen significantly.
A major contributor to the falling returns is the falling sales and increase in operating expenses
in 2010.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-28 Business Valuation (30 min)

The book value of equity, market value of equity (market capitalization), discounted cash flow,
enterprise value, and multiples-based valuations for Somerfeld for 2010 are shown below.
Book Value of Equity $ 1,285,000
Market Value of Equity 4,050,000= $2.25 x 1,800,000
Discounted Free Cash Flows 2,833,333=$170,000 x (1/.06)
Enterprise Value 4,555,000$395,000
Multiples-Based Valuation
Earnings Multiple 2,700,000=9 x $300,000
Free Cash Flow Multiple 3,060,000=18 x $170,000
Sales Multiple 5,250,000=1.5 x $3,500,000

The book value of equity is taken from the balance sheet, while the market value of equity is
calculated from the product of the total shares outstanding at year-end times the year-
end share price.
The DCF valuation is based on the assumption that free cash flows will continue indefinitely, so
that the discount rate used is the reciprocal of the cost of capital, or 1/.06.
The multiples-based valuations utilize the industry average multiples times Somerfelds
earnings, free cash flow and sales.

Overall, the valuations range from $1,285,000 to $5,250,000, a significant range. A wide range of
different values is not unusual however, given the significant differences in the assumptions of
the methods. The median for these measures, of approximately $3,000,000 should be a
reasonable start for any further analysis.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-29 Business Valuation (15 min)

Our analyst (cited below) decided to use a generous 110% ratio (enterprise value to sales) for
RCSH (greater than the 70% for Smith and Wollensky or the 80% for Mortons), and came up with
the following calculation of $94.4 million for the market capitalization (market value of common
shareholders equity) of RCSH at that time.

Note: The analyst likely used a generous enterprise value to sales ratio to provide a
conservative (i.e., high) estimate of the market capitalization for RCSH since the point of the
article was to show an upper limit on the possible value of the RCHS initial public offering.

Enterprise value = 1.1 x sales = 1.1 x $192.2 million = $211.42 million

And since: Enterprise value = market capitalization + debt - cash

Market Capitalization = Enterprise value net debt less cash = $211.42 - $117 = $94.42 million

At April 23, 2006, the market capitalization of RCSH was $523 million and the enterprise value
was $552 million, and the share price was $20. At January 9, 2009 the share price was $2, the
market capitalization was $50 million and the enterprise value was $215 million; the decrease
in market capitalization and share price reflects the decline in value for RCSH (and for other
restaurants) during this period. Note that the enterprise value has not changed significantly. For
an update, go to and select the stock symbol RUTH.

Source: Robert Barker, Take This Steak House IPO Out with a Grain of Salt, Business Week,
June 20, 2005, p. 160.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-30 Business Valuation (15 min)

The simple mean and median for the data are shown below; the standard deviation is
$18,557,104. A number of choices for the final valuation are possible. A choice within the range
of the mean and the median, $34,826,800 and $27,000,000 would be reasonable.

$34,826,800 mean $27,000,000 median $18,557,104 standard deviation

The analysts who participated in the valuation described here also participated in a market
valuation approach in which the analysts could confer, and change valuations over a period of
time, utilizing a specially designed web site. The valuations shown in the problem are the
opening valuations in this approach; later adjustments by each analyst, through participation in
the web site, resulted in a much smaller range of valuations:

$ 31,180,000mean
$ 30,000,000median
$ 5,090,383deviation

The standard deviation of the final round of evaluation, shown above, was $5,090,383, much
smaller than the $18,557,104 of the opening round. The point of the article is to shown that
communication among the analysts resulted in a smaller range of valuations, one in which it
was far easier to choose a final evaluation. In this case, a valuation of $30 to $32 million would
appear to be appropriate.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-31 Compensation; Strategy (20 min)

Stock options would be an excellent compensation tool for Corona because stock options are
highly motivating to managers; but they are not available because Corona is a private company.
The first thing that Corona could implement is a firm-wide bonus compensation pool. This
would provide an important incentive for coordination and cooperation among all the divisions
since all managers would share in the higher overall firm profits that result from cross-
divisional cooperation.
The firm should ensure that its overall strategic goals and critical success factors are included
in the new bonus plan. Fairness is also a very important aspect to consider when creating
compensation plans. In the interest of fairness, bonus plans should only be based on the
controllable aspects of the managers performance. This can be achieved by using relative
performance to prior years or agreed-on goals as evaluation metrics.
The current compensation plan appears to not support the corporations current position in
the sales life cycle. The high bonus and low salary combination were probably very appropriate
and motivating to managers when the company was in the growth phase. However, it now
seems that they are entering a maturity phase which means the compensation system would
need a more equal balance of salary and bonus. This will help solve the problem of managers
making decisions that are beneficial only to their personal divisions and not the firm as a whole.
Finally, the company should consider a deferred bonus component. This would help resolve
the problem of management turnover around the end of each fiscal year because deferred
bonuses are only paid to managers who stay with the firm. Deferred bonus plans can also be
advantageous in helping managers reduce their tax burden. This is an excellent tool for
attracting and retaining key employees.
Strategically, the company relies on its high-end image and growth for success. The
compensation scheme should be aligned with that. The use of the firm-wide pool will increase
cooperation between managers which should help to improve overall firm growth. Also, the
firm should use whatever compensation methods it can to attract the very best management
talent, since the company is experiencing a decline in profitability, and strong and effective
leadership is needed.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-32 Ten Ways to Create Shareholder Value (20 min)

Rappaports emphasis on shareholder value has a number of components that relate to cost
management, management compensation, and business valuation.

1.Throughout the 10 recommendations is a focus on long-term value as opposed to short term

measures such as accounting profit. Long- term value is best measured by critical success
factors as captured for example in the balance scorecard. This places an emphasis on using the
balanced scorecard in management compensation.
Rappaport emphasizes that stock price is a short-termmeasure, and does not effectively
measure the long-term success of the firm. Quoted in a recent CNN report, Rappaport said, I
dont know how many times I kept saying long term, long term, long term To me, shareholder
value is not about an immediate boost in stock price.
2.Recommendations 6 and 7 on management control focus on achieving long-term value and
shareholder returns. Again the balanced scorecard is a good fit for his intentions here, as well
as EVA which is a direct measure of economic value added. Rappaport is in effect saying the
BSC and EVA are key tools in performance measurement and therefore also in management
3.The emphasis is on strategic performance measurement, the type that produces long-
term results, not the type that focuses on the short-term results of the recent past.
4.Rather than to look only at purchase cost and book value, he urges top management to
continually review the market value of assets to determine if they can be more profitably used
elsewhere within the firm, or should be sold. This includes excess cash which should be
returned to the shareholders in form of cash dividends and/or stockbuy-backs.

Source: Alfred Rappaport, Ten Ways to Create Shareholder Value,Harvard Business Review,
September 2006, pp 66-77. See also,, May 19, 2009, Justin Fox, Shareholder
Value isnt so Dumb. Using Todays Stock Price to Gauge Success Is.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-33 Compensation at Non-public Companies (15 min)

1.The advantage of equity based compensation is that it aligns managers incentives with those of
the shareholder to increase shareholder value.
2.A recent survey by Deloitte Development LLC found that nonpublic firms are adding long-
term incentive programs to their compensation plans. The reason for the change to long-
term incentives is to achieve the desired alignment of managers incentives with those of top
management and the owners of the companies. Some nonpublic companies use bonuses based
on the increase in value of the company over time; this is where business valuation plays a key
role, since the compensation is based on business value. Other types oflong-term bonus
incentives include compensation based on earnings increases over time, often with the
restriction that the bonus is not paid unless the increase in earnings continues for a designated
number of years or quarters. The base might be cash flow, customer satisfaction, or any other
measure that is critical to the firms success.

Stock options and restricted stock grants are included in thelong-term program when
the non-public company is considering an initial public offering (IPO).

20-34 Compensation for Operational-Level Managers and Employees (20 min)

At the end of 2008 Wal-Mart and McDonalds were the only two companies in the Dow Jones
Index with stock price appreciation in the last quarter of the year. The two companies have
been able to survive and thrive in the recession because of their unique value to customers a
high value to cost ratio. McDonalds is well positioned to retain its best managers because in
2004 it began to offer a 401(k) plan that was well received in the company. The manager
contributes 5% of the managers salary to the plan and the company matches as much as 11%.
To make sure that managers are aware of the plan and its value, each manager is automatically
enrolled in the program. To participate, managers only need to contribute. The market
downturn in 2008 caused some managers to seek investment advice, but most are pleased they
have accumulated some savings using the plan.

The 401(k) was also valued highly in a Wall Street Journal study of Employee Benefits in small
businesses. Also highly valued were health insurance coverage, paid time off, and flexibility in
work schedules.

Reference: Lauren Young, Supersizing the 401(K) How McDonalds is Trying to Keep Valued
Managers especially African Americans, Business Week, January 12, 2009, pp 38-40; Simona
Covel, Picking the Perks the Employees Value, The Wall Street Journal, April 9, 2007, p B4.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation
20-35 Compensation in Tough Economic Times (15 min)

A recent survey by outplacement firm Challenger, Gray & Christmas [sic] reports that 20% of
companies are scaling back on perks and another 10% are considering it. The perks most likely
to go are travel related, since these are the most costly. Other companies are cutting back on
free cafeteria service (Google), free masseuse service (a Los Angeles law firm), company parties
(Viacom), dinner and cab fare allowances (Goldman Sachs), and company-owned jets (Alcatel-
Lucent grounded its three Gulfstream jets).

Other areas for potential reduction are bonuses, which have been eliminated or deferred in
many financial institutions at the end of 2008.

Other possible answers include reduction in health care coverage or reduction in contributions
to 401(k) plans. The difficulty here is that these are key benefits for many managers and there
should be a clear recognition of the dire need for the cutbacks for the managers to accept the
reductions as fair and equitable. The company needs to retain its best managers, especially in
difficult economic times, to help guide the company through the difficult time, and to be there
when the company begins to grow again.

Chapter 20 - Management Compensation, Business Analysis, and Business Valuation


20-36 Compensation; Machine Replacement (25 min)

This problem utilizes net present value concepts from chapter 12.

1. Annuity factor for 10 years at 10% is 6.145; Annual savings from lower operating costs
= $80,000 - $30,000 = $50,000
Initial outlay = $420,000 less $150,000 from the sale of the old machine = $270,000
NPV = -$270,000 + ($50,000 x 6.145) = $37,250.

Replacing the current packaging machine with the new machine is desirable because of the
$37,250 in present value savings.

2. Main expects to be with Choco-Lots for two more years. Thus the rewards to him of the
increases in net income caused by the lower operating costs are $1,000 = (1% of $50,000 x 2
years = $1,000). This does not offset the $2,100 decrease in Mains bonus caused by the
accounting loss on the sale of the first machine = (1% of [- $400,000 + $40,000 depreciation +
$150,000 on sale] = -$2,100)
Use of deferred bonus payments that emphasize the long-runeffects on net income could
remedy this situation. For example, awarding a bonus this year that pays 0 .2% of net income for
each of the next six years would change the costs incurred to Main. Stockoptions-
based compensation, exercisable in the future, would also cause Main to think about the long-
run effects of his decision.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-37 Compensation; Perks; Ethics (20 min)

1.The multiple levels of perquisites is a common practice and one that is well understood and
accepted. However, firms are obliged in ethics, equity and fairness to all employees and to the
shareholders to make decision regarding perquisites on a reasonable basis. The amount of
perquisites should be associated with the responsibilities of the manager, and should not be
considered an entitlement of any given level of employment. For example, an executive who
must work regularly with visitors from outside the firm should have the level of perquisites,
including a nice office, that will allow the executive to greet and make these visitors comfortable.
Managers should also be mindful, however, that an excess of perks will make many of these
visitors uncomfortable, and can cause an unfavorable image of the firm.

Moreover, it is becoming more common for top level managers to forego the excesses of
many managers of the past, and they have been rewarded by appreciation of shareholders and
improved loyalty and commitment of their employees.

2.Some of the instances described in the problem are probably within the firms guidelines as
acceptable use of perks. Often the firm will pay for the spouse of an executive to accompany him
or her on a trip where the presence of the spouse is appropriate and in keeping with the executive
role on that trip. Other instances may involve ethical issues which arise when perks are involved.
Each should be judged in the context of the management accountants position in the firm, the
significance of the amount of money involved, and the accountants professional responsibilities
as set forth in the Ethical Standards of the American Institute of CPAs and the Institute of
Management Accountants.

The firms policies about perks should be clear and fair and somewhat detailed, so that
issues such as these are not handled after the fact, but rather each manager knows the policies
about perks, and can avoid potentially unethical actions such as those described in the problem.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-38 Incentive Pay in the Hotel Industry (20 min)

1. The compensation would be as follows:
a. $83,249 = $60,000 + $.315(30,000) +$1,150(5) +$26.83(300) b. $74,410 = $60,000 +
$.315(25,000) +$1,150(3) +$26.83(115) c. $71,503 = $60,000 + $.315(28,000) +$1,150(0)

2. The compensation plan appears to be an effective one, as it includes all the key factors of
success which the partners are interested in. However, a key success factor for hotels, as for any
service firm, is to provide effective customer service, and none of the quantitative measures
includes customer service or satisfaction (though the occupancy goal is said to include service
quality, it is not quantitatively included in compensation). Thus, the compensation plan should
be reviewed with the purpose of making sure that it includes customer service in some significant
Also, the compensation plan fails to specify appropriate ranges for each of the three
criteria, to rule out the possibility that a manager will try to maximize earnings on one of the
three and neglect the other two. For example, a manager could earn a high bonus by setting
room rates very high, even though occupancy will probably fall.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-39 Incentive Pay Formula Development (30 min)

There are two goals, a goal for number of customers and a price goal:

Customer goal:
300/day target customers x 365 days = 109,500 customers weight x $12,800 = $6,400
$6,400/109,500 = $ .058 per customer served

Price goal: $6.88 target price

weight x $12,800 = $6,400
$6,400/688 = $9.30 per penny of average price per customer

Thus the compensation plan is:

$68,000 + $.058 for each customer served plus $9.30 per penny of average price per

Note that there are alternative ways to develop the compensation plan. For example, the
restaurant manager can develop a reward system which pays no bonus unless the average price
exceeds $6.88, or some pre-determined price level. And similarly, the customer goals might be
awarded only if the manager exceeds a given level of customers.
Also, the compensation plan suffers from the same limitations as described in 20-
38 above; namely, there needs to be a range or cap set on each criteria so that the manager does
not attempt to earn a high bonus by maximizing one of the criteria and ignoring the other.

2. If 280 customers are served per day at $6.75 average price per person, the total compensation
to the manager would be:
$68,000 + $.058(280 x 365) + $9.30(675) = $80,205
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-40 Compensation Pools; Residual Income; Review of Chapter 19 (40 min)

Asset Return on Return on
Turnover Sales Assets
Consumer Electronics
2008 1.739 0.126 0.219
2009 2.414 0.081 0.195
2010 2.410 0.091 0.219

2008 2.027 0.043 0.087
2009 1.719 0.035 0.060
2010 2.243 0.042 0.095

2008 8.791 0.024 0.209
2009 8.565 0.018 0.153
2010 9.504 0.025 0.239

GBI Total
2008 2.596 0.073 0.188
2009 3.058 0.049 0.151
2010 3.305 0.057 0.189

The ratio calculations clearly show that 2009 was a difficult year for GBI, as income and sales fell
for all three divisions. There was an improvement in sales and income in 2010 for all divisions.
Note that the consumer electronics unit was able to reduce its assets in 2009 so that its return
on assets fell only slightly, while the return on assets in the other divisions fell more sharply.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-40 (continued -1)

2. [Operating Income - (.08 x Invested Assets)] x .10 = Bonus

Total Bonus Bonus/Exec
2008 $ 1,085,152 $ 2,359
2009 $ 558,400 $ 1,054
2010 $ 920,300 1,568

As for the sales and income in 2009, the bonus amounts for executives fell sharply in
2009, then improved again in 2010.

Residual Income Electronics Cameras Computers
2008 925,152 15,000 145,000
2009 524,000 (44,200) 78,600
2010 710,000 32,400 177,900

Residual Inc Bonus per executive

2008 $ 3,084 $ 375 $ 1,208
2009 1,497 (1,105) 561
2010 1,893 876 1,017
Residual income fell for all divisions in 2009 and then improved in 2010. Residual income is
negative for the camera division in 2009. The negative bonus amount of $44,200 for the camera
division means that the camera division managers would receive no bonus in 2009 if the
bonuses were calculated based on each divisions residual income. Comparing the results for
the three divisions in parts 2 and 3, it is clear that the consumer electronics division managers
would benefit from the plan based on residual income. The consumer electronics division was
the major contributor to the firms overall residual income in all three years.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation
20-40 (continued -2)

4. Pros: The company-wide bonus plan promotes the sharing ofcorporate-wide assets. The bonus
plan also helps to keep talented managers that are running divisions that are not able to perform
up to expectations.

Cons: The company-wide bonus plan includes many factors not under the control of each
divisional manager. The bonus plan also penalizes executives of profitable divisions that do not
receive the total benefit because of non-profitable divisions.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-41 Compensation; Strategy Issues (25 min)

For companies with substantial growth opportunities or long product life cycles, bonus
plans based on short-term decisions may not adequately reflect long-term consequences of
managerial decisions.
MBI could consider a stock option plan that initially sets the exercise price of the option
at the current share price, but then periodically increases the exercise price by a growth rate
consistent with the companys cost of capital. Then the bonus plan would have
implemented long-term financial considerations before allowing stock options to be paid off.
MBI may want to consider granting stock options where the exercise price is adjusted
with the appreciation of an industry index. This will allow MBI to reward executives for an
increase in the value of their stock relative to that of companies facing similar risks.
MBI could also establish a bonus account system (deferred bonus system). Under this
system the executives do not receive the full amount of the bonus earned in a particular year. A
portion of the bonus is placed in an account and is only paid out to the executives in future
periods if they meet specified performance criteria in the future. This would minimize the chance
that executives would increase current performance measures at the expense of damaging
future performance.

Developing effective compensation plans is more difficult for multinational companies such as
MBI because foreign currency fluctuations, customs and tariffs, differences in taxation, and
political changes will all have an effect on the managers performance evaluation. The
multinational firm strives to identify all the factors that are controllable by the local manager
and include these in the performance evaluation and compensation plan. For example,
frequently managers of foreign SBUs are able to protect their unit from unfavorable currency
fluctuations by carefully chosen purchasing, sales, and financing practices.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-42 Executive Compensation; Teams; Ethics (30 min)

1. Universal should use the new measures to improve product quality and customer
a. At least three customer value-added measures for Universal Air Inc. include the
Availability of products to meet customer needs on a timely basis.
Price compared to the features and other benefits received (value)
The number of product returns that can be an indication of quality and reliability.

b. At least three process-efficiency measures for Universal include the following:

New product development time and introduction time to market.
Order fulfillment cycle time.
Modifications, rework, and other non-value-added time and activities.

2.At least three types of employee behavior that Universal Air Inc. can expect by having middle
management participate in the development of the second set of new performance measures
include the following:
Increased job satisfaction and morale, as well as a feeling of being valued
Better teamwork and cooperation.
A greater understanding of the company goals that should lead to commitment and ownership of
the goals.

3.To ensure that the cross-functional teams are effective, the executive management at
Universal Air Inc. needs to provide:
the necessary resources, including people and money
strong top management commitment to the process, clear communication of this commitment
and overall objectives to the functional managers and team members, and support for the
implementation of team-suggested changes.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-42 (continued -1)

incentive plans that reward performance for team participation as well as organizational
responsibilities. Better measurements may include the "balanced scorecard" concept.
4.Referring to the specific standards (competence, confidentiality, integrity, and credibility) in
the Institute of Management Accountants Statement on Ethical Professional Practice, John
Brogan's behavior is unethical for the following reasons:

Brogan is undermining the preparation of complete and clear reports.

Brogan is disclosing confidential information to someone outside of the company (Sara Wiley).
Brogan appears to be using confidential information for unethical advantage (i.e. brother-in-
law's personal objectives).

By curtailing the reporting of customer complaints, Brogan has failed to:
avoid a conflict of interest,
refrain from actively or passively subverting the organization's objectives.
communicate favorable and unfavorable information.

Brogan did not:
communicate information fairly and objectively disclose fully all relevant information.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-43 Executive Compensation (30 min)

1. a. The benefits to Jensen Corporation of a profit participation incentive plan for the Hobbit
Hole's restaurant unit managers include the following:
Increased employee interest in, and motivation toward the economic success of the company,
leading to goal congruence between the managers and Jensen. This could include improved
quality , better customer service, growth in customer base, and maintenance.
Unit managers see a direct reward link between their effort and their bonus and are, therefore,
motivated. Managers can readily compute the status of their bonus.
The plan is likely to be clear and have objective measures that are easy to understand.

b. The negative behavioral problems that could occur with the profit participation incentive
plan for Hobbit Hole restaurant unit managers include the following:
Greater emphasis placed on short-term rather than long-termobjectives. This could have a
negative impact on the company in the long term if items such as capital expenditures are
delayed to avoid short-term depreciation expenses.
There may be a number of issues affecting a particular unit's profitability that are beyond the
control of the unit manager, such as location or the local economy, and this could cause morale

2. a. The advantages to Jensen Corporation from having the motel unit managers of Cruise and
Snooze Inns participate in an incentive plan based on goal attainment include the following:
Improved employee motivation and ownership of the goals could result since the unit managers
have participated in establishing the goals. They know exactly what is expected of them.
The plan affords the ability to customize goals for a particular unit, i.e., a unit might be undergoing
renovation or have special targets for market improvement.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-43 (continued -1)

b. The disadvantages to Jensen Corporation from having an incentive plan based on goal
attainment for the motel unit managers of Cruise and Snooze Inns include the following:
There may be a perceived lack of management objectivity or fairness if goals are not consistent
among individuals. Employees could believe that goals are too subjective to be evaluated fairly
or that organizational politics could affect objectivity.
There are increased administrative costs due to the management time needed for setting and
evaluating the goals. There could also be increased operating costs due to quality control and
other efforts to reach the goals.

3. a. The behavioral problems that could arise for Jensen Corporation by having two different
types of incentive plans for Hobbit Hole and Cruise and Snooze Inns may be that unit managers
may complain and ask why their bonuses cannot be calculated like the other division's. For
example, Hobbit Hole managers may request to be evaluated on items other than just
b. The rationale that Jensen Corporation can give to the unit managers of Hobbit Hole and
Cruise and Snooze Inns to justify having different incentive plans for the two divisions include the
The goals of the two businesses may be different, and therefore should be measured on different
criteria in order to maintain goal congruence. For example, an improved physical plant may be
more critical in the motel business while profit may be a good measure in the restaurant business.
Also, the economic cost structure of the two businesses may be different with motels having a
much higher proportion of fixed facility costs and restaurants having more variable food and
labor costs.
The two divisions may have different incentive plans that are each an accepted practice in their
own industry.

Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-44 Business Analysis (45 min)

The following shows the ratios and an interpretation for each ratio.
a. Liquidity
Ratios Relevance 2005 2006 2007 2008 2009 2

The average number of times per yr.

A/R net
Turnover receivables turn into cash. Indicates 7.48 7.44 8.09 6.92 7
effectiveness of credit policy and
collections. Should be compared to
years and to industry averages.
An important measure of liquidity.
Current Should 1.01 1.23 1.66 1.92 2.23 1
Ratio be compared to prior years, industry
averages and debt restriction, if any.
A measure of liquidity like the
Quick current
ratio, but more conservative.
Ratio Includes .71 .77 1.06 1.23 1.43 1
only highly current assets-
(Acid Test) cash, marketable
securities, and receivables.
Indicates the average number of
Inventory times that
Turnover inventory is replaced during the year. 9.62 7.73 8.42 7.15 6
Measures inventory management
and can give an unsalable inventory.
Measures the degree to which cash
Cash flow flow
from operations covers the amount
ratio of .11 .25 .61 .42 .
current liabilities

Note: The free cash flow ratio is not calculated because information is not provided in the problem re
expenditures or dividends. (continued on next page)
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-44 (continued -1)

Liquidity looks OK overall, except for the recent buildup in inventory. The current ratio has f
below the bank restriction years ago, but has been safely above it in recent years. On the plus
cash flow from operations continues to improve, except for a decline in the prior year. Liquidity
l good, but it would also be useful to compare these results to an industry average to validate
b. Profitability

Ratios Relevance 2005 2006 2007 2008 2009 2

A measure of managements
Return on efficiency
Total Assets and effectiveness in using available 6.7% 12.1% 13.5% 2.6% 13

Return on A measure of managements

effectiveness in providing returns
Equity to 53.9% 71.8% 61.5% 10.5% 52.8
An important measure of
Gross Margin profitability.
Should be compared to prior years
% and to
relevant industry data. Reflects
over costs and pricing policies.
35.0% 36.0% 37.9% 38.2% 38.0% 40

Profitability is excellent in 2010, rebounding from a poor year in 2009. Will the improve
continue? Some concern for variability in sales and profit over the last few years.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-44 (continued -2)

The spreadsheet for the solution is shown below. The solution also shows the results of
extrapolating 2010 operations to 12 months.
Blue Water Yachts Company
Comparative Balance Sheet
For the Year Ended December
2005 2006 2007 2008 2009 (11 mos)
Cash $ 23,260 $ 21,966 $ 18,735 $ 28,426 $ 43,692 $ 31,264
Receivable 99,465 102,834 112,903 125,663 104,388 142,009
Allowance for
Bad Debts (9,304) (8,786) (8,824) (11,266) (7,282) (12,506)
Inventory 35,009 56,784 61,792 67,884 58,994 95,774
Other Current
Assets 11,894 12,894 9,024 11,006 18,923 22,903
Total Current
Assets $160,324 $185,692 $193,630 $ 221,713 $ 218,715 $ 279,444
Property and
Equipment 262,195 282,008 299,380 368,565 405,269 498,626
Depreciation (65,984) (93,442) (122,892) (158,099) (187,227) (226,307)
Total Assets $356,535 $374,258 $370,118 $ 432,179 $ 436,757 $ 551,763
Payable 82,635 78,127 63,346 56,256 40,189 49,544
Taxes Payable 11,630 10,983 11,780 14,083 3,738 15,632
Short Term
Loans 59,876 56,980 37,583 41,093 49,594 76,962
Payable 5,227 4,598 3,649 4,224 4,774 4,779
Total Current
Liabilities $159,368 $150,688 $116,358 $ 115,656 $ 98,295 $ 146,917
Long Term
Debt 158,173 172,388 179,490 214,997 229,471 262,258
Equity 38,994 51,182 74,270 101,526 108,991 142,588
$356,535 $374,258 $370,118 $ 432,179 $ 436,757 $ 551,763
Blue Water Yachts Company
Comparative Statement of Income and Operating
Cash Flow
For the Year Ended December
(11 mo.
2005 2006 2007 2008 2009 act.)
Sales $767,580 $724,878 $777,480 $ 929,478 $ 764,610 $ 938,857
Returns and
Allowances 38,379 35,645 40,334 45,998 32,887 46,380
Net Sales $729,201 $689,233 $737,146 $ 883,480 $ 731,723 $ 892,477
Cost of Sales 473,908 441,298 458,015 545,778 453,669 530,597
Gross Margin $255,293 $247,935 $279,131 $ 337,702 $ 278,054 $ 361,880
Expense $ 29,075 $ 27,458 $ 29,450 $ 35,208 $ 29,128 $ 35,563
Expense 18,597 19,557 20,998 21,475 24,889 28,993
Salaries and
Wages 81,923 73,664 77,846 95,764 92,903 99,447
and Legal 9,304 8,786 9,323 11,834 13,108 11,380
Expense 79,666 75,234 80,693 96,469 87,995 97,441
Other Expense 12,630 18,927 15,763 22,903 18,934 22,662
Total Expense $231,195 $223,626 $234,073 $ 283,653 $ 266,957 $ 295,486
Net Income $ 24,098 $ 24,309 $ 45,058 $ 54,049 $ 11,097 $ 66,394
Cash Flow
Depreciation $ 27,458 $ 29,450 $ 35,208 $ 29,128 $ 35,563
(increase) in
Receivables (3,887) (10,031) (10,318) 17,291 (32,397)
(increase) in
Inventory (21,775) (5,008) (6,092) 8,890 (36,780)
(increase) in
other Cr. Assets (1,000) 3,870 (1,982) (7,917) (3,980)
(decrease) in
Cr. Liabilities (8,680) (34,330) (702) (17,361) 48,622
Cash Flow
operations $ 16,425 $ 29,009 $ 70,163 $ 41,128 $ 77,422
Turnover 7.48 7.44 8.09 6.92 7.88
Turnover 9.62 7.73 8.42 7.15 6.86
Current Ratio 1.01 1.23 1.66 1.92 2.23 1.90
Quick Ratio 0.71 0.77 1.06 1.23 1.43 1.09
Cash Flow
Ratio 0.11 0.25 0.61 0.42 0.53
Gross Profit
Percent 35.0% 36.0% 37.9% 38.2% 38.0% 40.5%
Return on
Assets 6.7% 12.1% 13.5% 2.6% 13.4%
Return on
Equity 53.9% 71.8% 61.5% 10.5% 52.8%
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-45 Business Valuation (20 min)

Using most recent figures, the net book value for Blue Water Sailboats equity is $142,588,
taken from the balance sheet.
The earnings multiple method would take a projected value for earnings, as for example
the median value for the three recent years ($54,049) times the industry multiple of 8 =
$400,000. Similarly, the cash flow valuation would take a projected cash flow number (again
the median for the three most recent years, $70,163) times the industry cash flow multiple of
12 = $841,956. The appraiser uses judgment both in determining the amount of sales or cash
flow to use in the calculation, but also may adjust the industry multiple up (or down) if the firm
is expected to perform better (or worse) than the industry as a whole. The choice of the overall
valuation requires additional judgment; a median figure for the multiples valuations would be
approximately $500,000.

Summary of Valuations:

Valuation Method Valuation

Net Book Value of Equity $142,588
Earnings Multiple $432,392 = 8 x $54,049
Operating Cash Flow Multiple $841,956= 12 x $70,163
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-46 Business Analysis (50 min)

Calculations for financial ratios:
Balance Sheet 2010 2009
Current Assets $ 177,960,052 $ 137,209,072
Long-lived Assets 104,172,967 98,447,620
Total Assets $ 282,133,019 $ 235,656,692
Current Liabilities $ 122,365,299 $ 101,667,355
Long-term Debt 34,567,445 34,577,653
Shareholders Equity 125,200,275 99,411,684
Total Debt and Equity $ 282,133,019 $ 235,656,692

Income Statement
Sales $ 645,339,000 $ 589,645,335
Cost of Sales 498,657,788 453,887,390
Gross Margin 146,681,212 135,757,945
Operating Expenses 102,667,355 122,654,888
Operating Income 44,013,857 13,103,057
Tax expense 16,725,266 4,979,162
Net Income $ 27,288,591.34 $ 8,123,895.34
Cash Flow From Operations
Net Income $ 27,288,591.34 $ 8,123,895.34
Plus Depreciation Expense 16,774,653 14,662,893
+Decrease (-inc) in AccRec and Inv 38,219,191 -
+Increase (-dec) in Cur. Liabl. 20,697,944 -
Cash Flow from Operations $ 102,980,379.34 $ 22,786,788.34

-Capital Expenditures (22,500,000) (11,234,000)

-Dividends (1,500,000) (1,000,000)
Free Cash Flow $ 78,980,379.34 $ 10,552,788.34
Financial Ratios Industry
Accounts Receivable Turnover 9.12 6.96 5.50
Inventory Turnover 11.14 9.10 8.60
Current Ratio 1.45 1.35 1.90
Quick Ratio 1.13 0.86 1.10
Cash Flow Ratios
Cash Flow from Operations 0.84 0.22 1.40
Free Cash Flow 0.65 0.10 1.10

Gross Margin Percentage 22.7% 23.0% 33%

Return on Assets (Net Book Value) 10.5% 3.4% 19%
Return on Equity 24.3% 8.2% 28%
Earnings per Share $ 1.201 $0.358 $ 2.33
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-46 (continued -1)

A financial ratio analysis of JHPs liquidity shows a company that is improving quite well on all
measures. The receivables turnover and inventory turnover ratios are both significantly better
than the industry average and have improved significantly from 2009 to 2010. The current ratio
and quick ratio are lower than the industry average but have improved from 2009 to 2010, and
the quick ratio is now higher than the industry average.
JHPs cash flow relative to current liabilities has also improved significantly from 2009 to
2010 though both cash flow ratios are less than the industry average. The main reason for the
improvement in cash flow is the significant decrease in receivables and inventory; the company
employed much improved methods for managing these assets over the last year (note we have
assumed for simplicity that the balances of all accounts, including receivables and inventory are
the same in 2008 and 2009; the result is that the calculation of cash flow from operation for
2009 has no change for these two current asset accounts). Note also that JHP increased
dividends by $500,000 in 2010, with a negative impact on cash flow and liquidity. Overall, this
shows a mixed but improving picture for JHP relative to liquidity.

As to profitability, JHPs ratios have improved significantly from 2009 to 2010. However,
return on assets and return on equity are still lower than the industry average. Contributing
factors include the relatively low gross margin percentage which, at 22.7% in 2010, is somewhat
below the industry average. Operating expenses have decreased from 2009 to 2010, so the
focus now should be on improving the gross margin percentage, to reduce the cost of sales.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-47 Business Valuation (30 min)

1. & 2. Calculation of book value, market value, discounted cash flow, andmultiples-based values:
Book Value of Equity $ 125,200,275
Market Value of Equity 529,673,029=$23.45 x 22,587,336
Discounted Cash Flow 1,294,760,317=$78,980,379.34/.061

Multiples-Based Valuation
=$27,288,591.34 x
Earnings Multiple 368,395,98313.50
Free Cash Flow Multiple 695,027,338=$78,980,379.34 x 8.8
Sales Multiple 903,474,600=$645,339,000 x 1.40

3. The six measures provide a wide range of valuations, from a low of $125,200,275 for the
book value of equity to a high of $1,294,760,317 for the discounted cash flow method. The
discounted cash flow measure is relatively high because of the significant increase in cash flow
in 2010 due to the increase in earnings and to the improved management of receivables and
inventory, reducing both of these account balances from 2009. Also, the discounted cash flow
method is sensitive to the choice of the discount rate, in this case 6.1%.
The multiples-based measures range from $368,395,983 to $903,474,600 based on
current earnings, cash flows, and sales relative to the industry average multiples. Putting the
end points of the range aside, a conservative estimate of the companys value should be close
to $529,673,029, the market value of the firm based on the current market share price.

4. If the company is valued at approximately $529,673,029, this would reflect an expected

share price close to its current market value of $23.45. Thus, the $25 offer looks good. On the
other hand, if one projects a continued high level of free cash flow in the coming years, then
since the discounted value of the firm is much higher, the selling price of the company should
be somewhat greater than $25 per share. For example, at a discounted cash flow value of $1.3
billion, the implied stock value is approximately $60 per share. Now the $25 offer would not
look as favorable.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-48 Business Analysis and Valuation (30 min)

Financial Ratios 2010 2009 Industry
Liquidity Ratios
Accounts Receivable Turnover 19.05 15.00 10.00
Inventory Turnover 14.74 13.00 12.00
Current Ratio 2.81 1.68 2.00
Quick Ratio 2.36 1.28 1.50
Cash Flow Ratios
Cash Flow from Operations 0.91 0.60 1.20
Free Cash Flow 0.91 0.60 1.10
Profitability Ratios
Gross Margin Percentage 30.0% 27.8% 30%
Return on Assets (Net Book
Value) 5.6% 4.3% 10%
Return on Equity 8.9% 7.0% 15%
Earnings per Share $ 0.080 $ 0.060 -

An overview of the liquidity ratios shows that Gordon has a level of liquidity very favorable
relative to the industry average, and improving for all of the four ratios.
The cash flow ratios are also improving, but somewhat below the industry benchmark. Note
that since the company paid no dividends and had no capital improvements in 2009 or 2010,
free cash equals operating cash flows for these years, and the ratios are also the same.
The profitability ratios are improving from 2009 to 2010, but they are somewhat below the
industry benchmark. Overall, these ratios point to the need for Gordon to direct attention to
control of costs, improvement in profitability, with the likely result that cash flows will also
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-48 (continued -1)

2. Business Valuation

The measures, and the calculation of each is shown below.

Book Value of Equity $ 1,552,000(from balance sheet)
Market Value of Equity 4,950,000=1,650,000, x $3.00
Discounted Free Cash Flows 3,640,000=$182,000/.05
Enterprise Value 5,218,000$382,000
Multiples-Based Valuation
Earnings Multiple 2,904,000=22 x $132,000
Free Cash Flow Multiple 2,730,000=15 x $182,000
Sales Multiple 5,000,000=2.5 x $2,000,000
(Note that the calculation of valuation based on discounted cash flows assumes that the free
cash flows of $182,000 will continue indefinitely, so the present value is derived by dividing
$182,000 by the cost of capital, 5%.)

The valuation measures range from a low of $1,552,000 (book value of equity) to a high of
$5,218,000 for enterprise value. The consensus valuation would likely be $4 million plus,
depending on the analysts prediction of future cash flows. The DCF method has a conservative
valuation of $3,640,000 based on a free cash flow forecast of $182,000. Were this forecast to
increase to say, $225,000, the DCF valuation would be closer to $4,500,000. A key for valuing
this company, then, together, with the business analysis results, is to project whether the
company will be successful at improving its profitability and also improving cash flows.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-49 Executive Compensation; Regression Analysis (20 min)

1.Given the available information, the most reliable regression appears to be regression one, as
it has the highest R squared. Regression three is next best, and regression two is poor, an R
squared of only 11%

2.The regressions have some common patterns:

return on assets (ROA) is not a significant predictor of CEO pay for any of the dependent variables.
stock price volatility is significant at the lower level of reliability (.05) in the third regression only.
sales, stock returns, and CEO ownership are significant at .01 in all three regressions, indication
these variables appear to have an important role in CEO pay. Sales is a measure of the firms
size and would be expected to influence CEO pay. Stock return is a key performance measure
for shareholders and would also likely influence the Boards of these firms in determining CEO
pay. Notice that the CEO ownership variable is inversely related to CEO pay, that is, less
ownership means higher pay. The authors argue that this is consistent with the expectation
that lower levels of ownership require stronger incentives, and thus higher CEO pay.
There are mixed results for the remaining variables, passenger load, CEO tenure, and book to
market value. These variables are not significant in at least one of the regressions, indicating
there is potentially some relationship there but the nature of the relationship depends on the
dependent variable chosen, and that further analysis would be necessary to understand the
nature of the relationships between these variables and CEO pay.

3. The principal goal of the study was to identify a potential relationship between non-
financial performance, as measured by passenger load, and CEO compensation. Seven
additional variables were added to control for the expected effect of these additional variables
on CEO pay. The study shows this relationship is significant for the cash component of CEO pay.
The authors note that the relationships does not imply causality. They also note that since
many of the carriers included in the study were in financial distress at the time of the study, the
presence of this distress may have influenced the overall results.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-49 (continued -1)

4. The answers here could vary widely. One observation is that the information is applicable
only to the airline industry, and the results might not be generalizable to other industries.
Clearly the results indicate that certain financial variables have an important influence on CEO
pay, particularly size of firm variables (Sales) and stock returns. The fact that in this study CEO
ownership has a significant inverse relationship to CEO pay is more difficult to interpret. One
could argue that the CEO should be rewarded for taking a greater ownership interest.

Source: Antonio Davila and Mohan Venkatachalam, The Relevance ofNon-financial Performance
Measures for CEO Compensation: Evidence from the Airline Industry, Review of Accounting
Studies, 9, 2004, PP443- 464.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation
20-50 Business Analysis and Business Valuation (45 min)

1. First, determine the amount of cash flow from operations and the amount of free cash flow,
assuming that the 2008 and 2009 balance sheet values are the same. This means that there is
no positive or negative effect in the calculation of cash flow from operations for the change in
inventory or receivables. Second, calculate the financial ratios. The results are shown below.
Cash Flow From Operations 2010 2009
Net Income $ 76,783 $ 131,362
Plus Depreciation Expense 42,746 43,997
+Decrease (-inc) in AccRec and Inv (25,960) -
+Increase (-dec) in Cur. Liabl. (45,564) -
Cash Flow from Operations $ 48,005 $ 175,359

-Capital Expenditures (50,000) (100,000)

-Dividends - -
Free Cash Flow $ (1,995)$ 75,359
Financial Ratios Industry
Accounts Receivable Turnover 43.14 41.73 8.80
Inventory Turnover 8.85 8.24 7.00
Current Ratio 2.95 2.36 2.00
Quick Ratio 2.24 1.85 1.10
Cash Flow Ratios
Cash Flow from Operations 0.22 0.66 1.40
Free Cash Flow (0.01) 0.28 1.10

Gross Margin Percentage 18.8% 23.8% 30%

Return on Assets (Net Book
Value) 7.1% 12.3% 18%
Return on Equity 15.6% 28.9% 24%
Earnings per Share $ 0.117 $ 0.201 $ 1.15

The findings for liquidity are positive. All four of the liquidity ratios have improved over 2009
and are better than the industry average. The cash flow ratios, however, are relatively poor,
both declining from 2009 and significantly lower than the industry average. In particular, free
cash flow is negative in 2010. A key reason for the decline in the cash flow ratios is the decline
in income and the increase in inventory and receivables from 2009 to 2010. The decline in cash
flow is a real concern for JJP and should be given immediate attention.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation
20-50 (continued -1)
The profitability ratios are also poor. They are declining and below the industry average. In
particular, return on equity has fallen to approximately half of its 2009 value, from 28.9% to
15.6%. This is a very unfavorable sign for investors and, together with the decline in cash flow,
is a main reason for the decline in stock price from $5.50 to $2.34 from 2009 to 2010. The
reasons for the decline in income could be traced to the decline in gross margin percent,
indicating a rise in manufacturing costs and/or and inability to recover these costs increases in
increased prices. Also, operating expenses have increased significantly from 2009; the reasons
for the increase should be investigated thoroughly.

2.Six business valuations are calculated below for 2009 and 2010.
2010 2009Calc for 2010
Book Value of Equity $ 531,847 $ 455,064
=$2.34 x
Market Value of Equity 1,529,316 3,594,547653,554
Discounted Cash Flow (35,000) 1,322,086=$(1,995)/.057

Multiples-Based Valuation
Earnings Multiple 1,612,433 2,758,599=$76,783 x 21
Free Cash Flow Multiple (17,556) 663,158=($1,995) x 8.8
Sales Multiple 3,494,401 3,202,395=$1,588,364*2.2

Note that every valuation measure except for book value of equity has declined from 2009 to
2010 due to the decrease in cash flow and the decrease in income. In fact the 2010 valuations
based on free cash flow are negative and therefore are excluded from further analysis (we do
not believe the firm has negative value, nor that the negative free cash flows will continue into
the coming years). As is often the case, the valuation measures vary widely, from the low of the
book value of equity to a high based on the sales multiple. A variety of interpretations is
possible. Our approach would be to choose a value of approximately $3 million for 2009
because the sales multiple, market value of equity and earnings multiple are centered near that
point. For 2010, our judgment would be conservative, given the recent decline in net income
and cash flow.
Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-50 (continued -2)

So, we would exclude the sales multiple as an outlier in 2010 and choose a value close to that of
the market value of equity or the earning multiple, or approximately $1.5 million. This is a drop
of approximately 50% in market value in one year, a serious concern for JJP.

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