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IAI Actuarial Core Principles · Business Finance · Key principles of finance

A company's managers are paid a bonus based solely on this year's reported earnings. Which behaviour is this scheme most likely to encourage, to the detriment of long-term shareholders?

Managers are most likely to cut discretionary spending such as research and maintenance. This raises current reported earnings, and hence their bonus, while reducing long-term cash flows and shareholder value, illustrating how poorly designed incentives create short-termism.

  1. AAccepting every positive-NPV project regardless of its short-term earnings effect
  2. BCutting research and maintenance spending to lift current earningsCorrect
  3. CIncreasing dividends beyond earnings
  4. DRetaining excess cash for shareholders
  5. Disclosing more information to the market

Explanation

A short-term earnings metric rewards managers for boosting current profit even when value falls. Discretionary spending on research and maintenance reduces expenses now but harms future cash flows. Positive-NPV acceptance would be value-enhancing, so it is not the likely harmful behaviour.

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