Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

The annual reports of commercial corporations increasingly contain details of share option schemes.

You are required:
(a) To discuss whether share option schemes for either directors or employees generally, can benefit the interest of the shareholders in the company;

(b) Contrast share option schemes with other schemes for relating managers‟ rewards to the financial
performance of the company;

(c) Describe the treatment of share option schemes in calculations of earnings per share.
ANSWER
(a) Individuals (and institutions) become shareholders for economic motives (dividends/capital growth). The ability of a company to meet shareholders‟ objectives paying a high dividend and/or having an increasing share price depends upon the future profitability of the company. If decision making was in the hands of the shareholders then one would assume that all decisions would be made in the pursuit of profitability. However, the divorce of ownership and control has put the responsibility for decision-making in the hands of professional directors/managers. It follows that decisions made directors/managers ought to be consistent with shareholder wealth objectives. However, the directors/managers have considerable scope for pursuing their own personal objectives which might not be identical with those of the shareholders ie, there is likely to be a lack of complete goal congruence, and shareholders‟ objectives might be subordinated to managerial objectives.

Share option schemes for managers (and other schemes discussed below) are intended to harmonise managerial and shareholder objectives giving management the same wealth objectives as the shareholders. Managerial and shareholder objectives are still unlikely to become perfectly congruent since managers are likely to have objectives other than wealth maximization to be satisfied through their employment (e.g. power, status/esteem, control over resources etc) which might not be perfectly correlated with wealth maximization.

If managers are motivated wealth objectives then they are likely to take decisions in line with maximizing the share price at the exercise date and to maintain/increase the price thereafter, in which case shareholders‟ interests will benefit.

Share option schemes for employees (as opposed to managers with decision making authority) are introduced for the same reason as those for managers, to improve profitability working more efficient/effectively.

For a „reward‟ to be effective as a motivator it needs to be of a significant amount and the recipient needs to associate the reward with the actions which gave rise to it (i.e, efficient working leading to higher profit). In the case of share option schemes for employees if the number of shares which the employees could take up is high, and the company is fairly labour intensive then the shareholders‟equity could well be diluted. If the number of shares per employee is small then the scheme is unlikely to act as a motivator.

If the options were to be given every year or twice per year, it would be difficult for the employees to associate such a „reward‟ with their own effort. For any particular employee the amount of corporate profit will almost entirely be outside his/her control. Managerial decisions, conditions in resource and profit markets, competitive actions etc. all have a very significant effect upon the level of profit and are not controllable employees throughout the year. It is doubtful whether a share option scheme based on annual profit could motivate an employee to work more efficiently during any particular day or week his/her effort in any short period would have no noticeable/measurable affects on the corporate profit for the year. Shorter term bonus schemes relating to the efforts of individuals or small groups and based on their measurable performance are more likely to act as motivators.
In summary, share option schemes for managers are likely to benefit shareholders while those for employees in general are less likely to have much benefit except to the extent that they may influence employees to take a greater interest in the affairs of the company.

(b) Other schemes can be sub-divided into two sections:

(i) those giving rewards based on overall corporate financial performance;

(ii) those giving rewards based on the financial performance of the sub-unit for which the individual manager is responsible. (Investment center, profit center, revenue center or cost center.)

The latter type may well be preferable since they relate reward with individual responsibility.

Rewards can be in terms of cash „bonuses‟ or equity. Giving financial benefits to managers based on profits greater than budget or costs (lower than budget) on a periodic basis may well lead managers to take action to maximize profit or minimize cost in each accounting period. It is doubtful whether such actions would be consistent with the maximization of shareholder wealth since managers‟ focus on attention is the short term. Profits can be boosted in the short term foregoing expenditures necessary for longer term profitability. If the benefit is in the form of equity then to harmonise shareholder and management objective some restrictions should be imposed concerning the sale management of their equity, otherwise „short-termism‟ could be pursued.

Share option schemes can overcome such problems of concentrating on the short term careful selection of the exercise date of the options. The exercise date should not be too early because of
„short-termism‟ nor too late because this would considerably reduce the motivational force.

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