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Hi, Ken, there is a question asking for the benefit and problem of the proposed reward system as per Q.3 Dec 2022 appears on the practice platform.
Here are the statements:
“The shareholders have been negotiating the terms of the ESOS with the board for some time. Subject to your advice, they are about to approve a deal where each director will be given an option to buy 200,000 shares in two years’ time at today’s market price of $1·70 per share. In two years’ time, each director can decide whether or not to exercise their share options depending upon the prevailing share price. The directors’ basic salary will not change following the introduction of the ESOS.”
Then, I want to enquiry
1. How does the share option run? (whole processes: buy option, sell option, exercise prices is higher / less than share prices)2.In the scenario, the institutional investor believe that this insurance company’s recent poor performance (inefficiency, impoliteness occurred in call center staff) may be due to this reward system. Do you think such reward contributing to negative aspect of daily running performance?
1 The option is a simple buy option that can be exercised in two years at $1.70. If, by then, the share price is, say, $2.50 (or anything > 1.70) then the option would be exercised as the director can buy at 1.70 and sell at the current price of 2.50. If the share price had fallen to, say 1.00, the option would be allowed ro lapse (why buy at 1.70 using the option when you can buy ob the market at 1?) The option is not a traded option and is simply an agreement with the director. It is assumed that the option will focus the directors’ minds on increasing the share price so that they can make larger profits by exercising the option.
2 The tricky thing about options to incentivise staff is setting the exercise price that encourages real effort. Set it too high and directors kigh conclude there is no hope of getting the share price high enough for them to make a profit. Conversely, setting too low an option price risks rewarding directors foreshore price rises that would happen anyhow with mediocre management. I think that the shareholder Knight suspect that the directors have deliberately caused the share price to fall, so that a low option exercise price is set. Then, for little effort the directors engineer that the share price rises to be above the exercise price, creating an easy profit for them
Ken, as you have mentioned the shareholder suspects of directors’ malpractice of controlling the share option price at the lowest level and gain a future enormous profit after exercising their options, this reward scheme has been mis-employed as self-earning of profit rather than incentivise them to improve the underperformance of daily operation of call centre service quality. Here, the question asks for advice on benefits and problems of such scheme. Is it advantageous to me to place equal balance of each issue (i.e. 3 for benefits and 3 for drawbacks) to earn marks? Note: this sub-part question is 8 marks.
Finally, this kind of issue does not appear in the APM syllabus. How do I encounter it? I have studied FM at an very earlier period and I have almost forgotten them. Do I need to read more e-business magazines so as to regain the related knowledge? Can you recommend other issues of magazine that can help me?
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