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ACCA Applied Skills · Financial Management · The nature and purpose of financial management

A company's managers are rewarded with a bonus based on this year's reported profit. Which behaviour is this scheme most likely to encourage, to the detriment of shareholders?

Annual-profit bonuses encourage short-termism, so managers may reject positive-NPV projects whose profits arrive late or are low in the first year. This reduces shareholder wealth because value-creating investments are forgone to protect the managers' current bonus.

  1. ARejecting a project with a positive NPV but poor profit in its first yearCorrect
  2. BInvesting in projects that have a higher NPV than the cost of capital
  3. CRetaining all profits to finance profitable investments
  4. DDisclosing more information to shareholders voluntarily

Explanation

A bonus tied to annual profit encourages short-termism. Managers may reject projects with a positive NPV if early-year profits are low, for example because of start-up costs or depreciation, even though accepting them would increase shareholder wealth. The other options are consistent with, or neutral to, shareholder wealth maximisation.

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