Page 381 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 7. Short-Term Incentives 367

Since companies in the mature stage are less likely to generate fluctuations of the magnitude
of a threshold or growth company, developing a bonus fund is less risky.
Economic Profit Plans. One popular deductible formula is the economic profit formula that
allows deductions for the use of capital (usually both long-term debt and equity). Economic
profit is not new. Economists dating back to Adam Smith have contended that in order for
business to be successful it must produce a competitive return on its capital, or economic
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profit. Some refer to these plans as economic value added (EVA). (EVA is a registered trade-
mark of Stern Stewart & Co.) General Motors was one of the first to use this type of plan.
Economic profit equals income less the cost of capital. Therefore, one must define three items:
profit, capital, and cost of capital. Profit probably should be operating income (which excludes
interest expense, depreciation, and amortization of goodwill) less taxes. Some refer to this as
NOPAT (net operating profit after taxes). Capital is the sum of debt and shareholder equity.
The cost of capital is what borrowers are charging directly (debt) or indirectly (shareholder
expected return). Cost of capital could be a blended rate (i.e., one rate that includes both
debtor and shareholder) or separate calculations for each. To illustrate, assume a company
has debt of $60 million and shareholder equity of $20 million. Assume borrowing costs are
8 percent and expected shareholder minimum return is 12 percent (risk-free government
security of 6 percent plus a 6 percent equity-risk premium). The cost of capital would be
$7.2 million (i.e., $60 million 0.08 $20 million 0.12). If profit is defined as net oper-
ating income after taxes and that figure were $10 million, then the economic profit would be
$2.8 million (i.e., $10 million $7.2 million). Obviously, one improves economic profit (EP)
by increasing operating income and/or reducing the amount and/or cost of capital.
The above is a very simple example. The formula can be far more exacting. However,
as the formula becomes more detailed in an attempt to be a more valid measurement, it
becomes more complicated and difficult to understand. If the bonus candidates do not
understand the program, it is unlikely to drive their behavior, regardless of its precise accu-
racy and relevance. In addition, EP is not a substitute for business strategy; rather, it should
support the business strategy. Furthermore, some choose to use multiple-year periods,
thereby converting the original short-term bonuses into long-term incentives.
Economic profit formulas will expose companies that are growing profits in absolute
amounts while doing so at an increasing cost of capital and thereby destroying, not creating,
additional capital. One could say this results in economic value lost (EVL). Companies with
little capital and high growth rates may not be as interested in economic profit formulas as
those with a large infrastructure of buildings, equipment, and inventory but more modest
growth rates. Stated another way, economic profit formulas may be more appropriate for
companies in the later stages of the market cycle than those in the earlier stages.
Selecting the most appropriate formula is very important. For example, using a
deductible formula in regard to return on capital can encourage management to avoid making
full use of its borrowing capacity. If the bonus fund were generated by a formula taking
8 percent of net income in excess of 10 percent on capital, any investment return of less than
10 percent (after taxes) would lower executive bonuses. For example, it might be attractive
from a shareholder viewpoint to borrow at 9 percent pretax (4.5 percent after tax assuming a
50 percent tax rate) and get an 18 percent pretax (9 percent after-tax) return, but since this
action would reduce the bonus fund, it is financially unattractive to management.
In any event, fund formulas need to be reviewed on a regular basis to ensure they are
consistent with current company conditions. One reason that many plans developed 10 or