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ACCA Strategic Professional · Strategic Business Leader · Agency

Ormond Group's board proposes a bonus scheme for executives based on earnings per share (EPS) growth. A shareholder notes that executives could meet the target by borrowing to buy back shares, even if this increases financial risk and reduces long-term value. Which response best reflects sound agency-cost management?

Using a balanced set of measures such as EPS, return on capital employed and gearing limits, set by an independent remuneration committee, is best. It stops executives gaming a single metric through debt-funded buy-backs while keeping pay linked to performance, so agency costs fall without losing alignment.

  1. ARetain the EPS target, because any EPS increase benefits shareholders
  2. BRemove all performance-related pay to eliminate manipulation
  3. CCombine EPS with other measures such as return on capital employed and risk or gearing limits, assessed by an independent remuneration committeeCorrect
  4. DAllow the executives to choose the performance measure that suits them best

Explanation

A single metric can be gamed, as buy-backs funded by debt raise EPS while increasing risk. A balanced set of measures with gearing constraints, set by an independent remuneration committee, reduces manipulation while retaining alignment. Removing pay-for-performance loses alignment, and executive choice of measure is itself an agency problem.

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