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ACCA Strategic Professional · Advanced Financial Management · The role and responsibility of senior financial executive/advisor

Kestrel Group's board proposes a CEO bonus equal to 1% of reported profit before tax. The CEO could choose between Project A, which yields a profit before tax of $10m next year but a negative NPV of $4m, and Project B, which yields a profit before tax of $3m next year with a positive NPV of $6m. Which statement is correct?

The scheme encourages short-termism. Project A yields a $0.10 million bonus against $0.03 million for Project B, so the CEO is motivated to pick A even though its NPV is negative. Rewards based on single-year accounting profit do not align with long-term shareholder wealth.

  1. AThe bonus scheme is congruent with shareholder wealth because both projects affect profit
  2. BThe bonus scheme encourages short-term profit focus, so the CEO may choose Project A, which destroys valueCorrect
  3. CThe bonus scheme will encourage the CEO to choose Project B because its NPV is higher
  4. DThe bonus scheme eliminates the agency problem since the CEO is paid by results

Explanation

A bonus based on one year's accounting profit gives 1% x $10m = $0.10m under A versus $0.03m under B. The CEO therefore prefers A even though its NPV is negative, so the scheme is not aligned with long-term shareholder wealth. A measure based on value creation such as EVA or TSR over the long term would be better.

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