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Assessment cover sheet

Exam Number: F10075

Word Count: 1557

CRANFIELD SCHOOL OF MANAGEMENT

Full Time MBA Programme 2010/11

Term: 1

Part: 1

EOS WAC

This assessment/report is all my own work and conforms to the Universitys

regulations on plagiarism

An identical copy of this document has been submitted to theTurnitin system

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Contents

EXECUTIVE SUMMARY 3INTRODUCTION 4ANALYSIS OF THE CURRENT SITUATION 4SUGGESTIONS 6Suggestions 6Conclusion 8

Team Appendices 10Appendix 1 - Principal-Agent Theory 10Appendix 2 - Satisfying Behavior 11Appendix 3 - Marris Growth Maximisation Model 12Appendix 4 - Sales Maximization Model 13Appendix 5 - The Williamson Model 14

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Pay Structure and M&A problems

The current NewTech pay structure incentivises the CEO by the growth of the sales volume.

According to the Sales Maximisation Model3, the outcome of this incentive will be the desire

of the management to maximise revenue through the sales growth, as opposed to profit

growth. This causes the growing discontent of the shareholders since the return on profit is

below the market levels. Furthermore, the focus on Sales growth causes the CEO to exhibit

the satisfying behaviour4, when the performance metrics are achieved through the first

possible solution - Mergers and Acquisitions, by acquiring mature companies with

established sales volumes. There are several flaws with this approach; firstly, this results in

Organisational Slack5, whereby the management is not utilising the NewTechs R&D and

patent potential. Secondly, M&A do not usually bring expected value to the

company6(Elmutti and Kathawala, 2001)7, and thus acquiring established Cash Cows8 in

such dynamic industry as electronics may prove to be counter effective, when, with the rapid

development of technology, they turn into low profit Dogs.

Metrics Used

Additionally, the benchmarking system used by the committee is prone to errors. The salary

is calculated through the survey of public companies within Europe. It is argued that the

scope of this comparison is far too broad and generic, as different industries and countrieswill have different tax levels and incentive policies. Furthermore, the salary is set within the

50 percent and the 75 percent pay percentile, which is also argued to be too excessive and

may be the evidence of conflict of interest by the chairman of the committee. The

remuneration committee has discretion on the weighted average of the combined

measurement index, which may be a cause for corrupted practices.

3Please see Team Appendix 4, Sales Maximisation model and its applications for New Tech

4 Please see Team Appendix 2, Satisfying Behaviour5 Please see Team Appendix 2, Organisational Slack6 Please refer to Team Appendix 3 Marris Growth Model7

Elmuti, D., Kathawala, Y.,(2001) An Overview of Strategic Alliances. Management Decision. Vol. 39 (3),

pp.205-218

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CEO Expense Preference

Finally, the CEO has also diverged from profit-maximising behaviour by making investments

for non-productive purposes, in accordance with Williamson expense preference model9.

Some examples of these discretionary expenditures are also the indulgent incentives

(luxurious office, team of personal assistants) and involvement in CSR10

at the time when

profits are below par.

SUGGESTIONS

Suggestions

Based on the above findings, the following solutions are proposed in order to incentivise the

CEO, increase NewTechs value and encourage an approach with reduced risk aversion.

Remuneration Structure

It is argued that the current remuneration structure does not correspond with the profitability

goals of the company and its shareholders. It is therefore strongly suggested to decrease the

overall share of fixed salary of the CEO and increase bonus percentile, which will be linked

to new performance measurements based on profit sharing scheme. Evidence shows, that

profit sharing with the agent can significantly increase the value of the firm, while avoiding

costly schemes, it helps to generate great returns in shareholder value (Haubrich, 1991)11

.

Furthermore, it is proposed to remove the board discretion in selecting the weight of the

metrics in the combined performance measurement index, to make the process more

transparent and remove potential conflict of interest. It is also suggested to replace the

chairman of the committee, Henry OLeary, to a more independent figure, without any

professional or friendship ties to MJ. In order to introduce more risk prone behaviour by the

CEO, it is further suggested to eliminate both the bonus upper cap and bonus floor. This will

achieve both goals: i.e. rewarding exceptional performance and penalising below average

results.

9Please refer to Team Appendix 5 Williamson Expense Preference Model

10Please refer to Glossary Corporate Social Responsibility

11Haubrich, J.G.,(1991) Risk Aversion, Performance and Principal-Agent Problem,

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Metrics

It is strongly advocated to abolish the sales growth variable, substituting it with the Net

Return on Assets metric, based on historical performance of the company andtied with the

industry performance (benchmarking). This will result in increased risk taking initiatives

from the CEO, as he will be incentivised to grow companies profitability above competitive

rates. The CEOs payment benchmarking should be based on the surveyof public companies

in the same industry and preferably in the same country, as opposed to current practice,

discussed previously.

Shares and Stock Options

It is recommended to introduce stock options as part of the CEOs remuneration package. It is

empirically proven that providing stock options as part of the CEOs pay aligns his interests

to those of shareholders and entices him to exert risk-seeking behaviour12

. Providing MJ with

stock options will also increase his interest in the long- term performance and make him more

of a principle than an agent13. The stock options should also be linked with companys long-

term share prices, that is, they can only be exercised when the NewTechs shares show long-

term appreciation. It is argued to reduce the threat of short-term risk taking to boost share

price by the CEO.

Dismissal Probability and Salary Penalties

While it is not suggested to implement dismissal policies for the CEO, it is nonetheless

recommended to reduce his fixed salary in proportion to stock options, if the NewTechs

share price is underperforming. Evidence shows that the later increased the efforts exercised

by the agent to overturn a falling stock.14 At the same time, additional negative incentives

may increase risk aversion by the CEO, as he will be afraid of failure15

.

12Jensen, M. C., Murphy, K.J., (2004) CEO IncentivesIts Not How Much You Pay, But How,

13 Wolff, F.C.,(2004) Employee stock option compensation,

14 Edmans, A., Gabaix, X.,(2009) Incentive accounts: A solution to executive compensation,

15 Pearson, M.A.,(2000) Enhancing the Quality of CEO Compensation Disclosures. Mid-Atlantic Journal of

Business,

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Conclusion

The findings of the report indicate that highlighted inefficiencies in current remuneration

process need to be promptly eliminated. Failure to do so may undermine long term company

growth and further deteriorate relationship between shareholders and management. It isstrongly recommended that the above recommendations are implemented as soon as possible

in order to offset the situation. Additionally, there is strong empirical and practical evidence

that implementation the solution will bring long term growth and increased value to

NewTech, its management and shareholders.

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References & Bibliography:

Elmuti, D., Kathawala, Y.,(2001) An Overview of Strategic Alliances.Management

Decision. Vol. 39 (3), pp.205-218

Haubrich, J.G.,(1991) Risk Aversion, Performance and Principal-Agent Problem,

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Team Appendices

Appendix 1 - Principal-Agent Theory[1]

The shareholders of NewTech (principal) have designated Michael J McManus

(agent) as CEO to run the company. However, in the presence of bounded rationality[2],

which means that the shareholders do not have access to and cannot manage all the

information related to how NewTech is run, they have not been able to come up with a

complete contract describing all the contingencies that may arise. Also, the goals of the CEO

might be different from those of shareholders. Therefore, shareholders need to ensure that

they provide the proper incentives for the CEO to maximise profits and dissuade him from

engaging in activities that might go against their interests.

[1]This section is based on Rickard, S (2009), CORPORATE CONTROL AND ORGANISATIONAL DESIGN,

Economics of Organisations and Strategy Course Reading, Cranfield University and on Rickard, S, EOS

GLOSSARY, Economics of Organisations and Strategy Course Reading, Cranfield University.

[2] Bounded rationality is a concept developed by Herbert Simon.

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Appendix 2 - Satisfying Behavior 16

It refers to the agents (the CEO of NewTech) behaviour in engaging in the first alternative

that satisfies the performance targets set in his remuneration scheme, EPS and sales volume,

instead of trying to find a better alternative that would maximise shareholders value.Satisficing behaviour might result in organizational slack17, a behaviour which leads senior

managers, in our case the CEO, to not fully utilize NewTechs resources, sleeping patents

and human capital, but to engage in activities with minimum impact in shareholders value

like mergers and acquisitions of mature companies.

16 This section is based on Rickard, S (2009), CORPORATE CONTROL AND ORGANISATIONAL DESIGN,

Economics of Organisations and Strategy Course Reading, Cranfield University and on Rickard, S, EOS

GLOSSARY, Economics of Organisations and Strategy Course Reading, Cranfield University.17 Behaviour that leads to inefficiency in the firm

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Appendix 3 - Marris Growth Maximisation Model

Marris model helps explain the trade-off between NewTechs current growth strategy and

shareholder value, specifically in terms of the proportion of the profits paid out as dividends

to the shareholders. Robin Marris dynamic model examines managerial discretion withrespect to the rate of growth. NewTechs rapid growth/diversification stretches its

organisational coherence18 thereby incurring opportunity costs of declining efficiency. As

shown below, central to Marris theory is an inverted U shaped relationship between the

return on capital and an increasing rate of diversification as shown in figure.

The x-axis is the rate of growth (i/K), and the y-axis, is the profit rate (Tg/K). Lines A and

B show different levels of retained profits. At point A, the rate of growth regenerates the

maximum profit rate. The range between A and B represents the area of discretion open to

CEO in tradingoff growth with the profit rate. In other words, if the CEO invests a higher

proportion of profits (B) retained in diversification, the firms profit rate decreases.

The range beyond B, say B to C, represents a profit rate that shareholders will find

unsatisfactory raising the threat that the firms CEO could be replaced or the firm will be

taken-over by a rival. Continued acquisitions could push NewTech towards C.

18Ability of a firm, as it grows large and engages in diversification, to keep its workforce focussed on common

goals, to encourage new thinking and ideas without sacrificing efficiency.

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Appendix 4 - Sales Maximization ModelAccording to Profit Maximisation Theory proposed by William Baumol, in the competitive

market firms are aiming to maximise revenue through the maximisation of sales. He stated

that in modern organisations, management is separated from the owners; hence the goals ofthe two are different. As indicated by Baumol, managers salary and benefits are often linked

to firms Volume of Sales; therefore they are more interested in maximising the revenue,rather than increasing profit. Additionally, managers are often motivated by personal prestige

of increased sales and find that sales are easier to use as targets for motivating staff. This isfurther indicated by the Figure 119

The figure shows the shortrun situation facing a single product firm and the shape of the total

cost curve, TC, reflects diminishing returns. The firm faces a downward sloping demand

curve; hence, increasing the volume of sales involves a falling price and if unchecked,

eventually a price equal to zero. A sales revenue maximising firm would wish to set output at

q2 determined by point D. A profit maximising firms output would be q1 where the

difference between total revenue, A, and total cost, B, is maximised: AB = q1C. Givenasymmetric information shareholders are unable to locate point C and instead specify a

minimum profit which then becomes a constraint on the managerial discretion. Managers will

therefore produce that level of output which generates the highest level of sales revenue while

delivering the minimum profit performance: this would mean producing output q3.20

According to Baumol, the objective of the firm is to satisfy minimum profit levels expected

by the shareholders, and use the available funds for further expansion. If, however, the firms

profit is below the levels expected by the shareholders, this may, in time, result in shareholder

dissatisfaction with the management.The above scenario is definitely applicable to NewTech current situation. The CEO and the

general management incentives are tied to companys Sales growth. Thus, management is

fuelling the expansion through Mergers and Acquisitions, in order to achievesales growth

targets. Meanwhile, the shareholders are dissatisfied with below the industry averagereturn

on assets, due to lower profitability.

19Sales Maximisation Concept William Baumol

20]This section is based on Rickard, S (2009), SALES MAXIMISATION MODEL, Economics of Organisations

and Strategy Course Reading, Cranfield University and on Rickard

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