Reference no: EM13921100

Bonus Plan Adjustment

a. Making Kraft's compensation sensitive to such uncontrollable events increases the riskiness of her compensation. If Kraft is risk-averse, the firm will have to pay her a compensating differential for the compensation risk she is being required to bear. The firm must decide whether the (present value of the) compensating differential is greater or less than the increase in firm value as a result of making Kraft responsible for such events.

b. Why might it be value increasing for the firm to make Kraft accountable for such events. It is true that she cannot control those events. However, there are things she can do to minimize the consequences of the events. She can hedge against fluctuations in gold prices, and she can buy earthquake insurance. (It is not clear, however, that the cost of such hedging and insurance is greater than the benefits to the firm.) You will see more discussion of these issues in corporate finance. More importantly, Kraft can take actions after such events that reduce the costs to the firm. For example, after the earthquake, Kraft probably could have made a number of decisions that shortened the amount of time the plant was closed. If Kraft is not held accountable for the costs of the earthquake, then she has no incentive to take such cost-reducing (value-increasing) actions.

There is also the issue of influence costs. If the firm decides not to hold Kraft ac- countable for such events, then Kraft has incentives to argue that a lot of costs are as- sociated with the events (i.e., more costs than actually were associated with the event). She will also argue that a lot of events were uncontrollable. Senior managers must therefore devote energy to determining which events were uncontrollable and which were not, and which costs were associated with the events and which were not. The firm does not incur these costs if they adopt the policy of making Kraft accountable for profits regardless of unforeseen events.