A company's directors have decided to provide senior managers with a performance bonus scheme. The bonus scheme entitles the managers to a cash payment of 10,000 should the company share price have increased by more than 20% at the end of the next 6 months. In addition, the managers will be entitled to 5,000 free shares each, should the share price have increased by more than 10% at the end of the next 6 months. You are given the following data:

Current share price 7.81

Risk-free rate 5% pa (continuously-compounded)

Share price volatility 25% pa

No dividends to be paid over the next 6 months.

i.By considering the terms of the Black-Scholes call option pricing formula, calculate the value of the bonus scheme to one manager. [2 MARKS]

ii.Explain the main disadvantages of this bonus scheme as an incentive for managers to perform. [2 MARKS]

iii.Some shareholders are concerned that this scheme might cause an undesirable distortion to the managers' behaviour. Suggest some modifications to the scheme that will ensure that the managers' aims coincide with the long-term objectives of the shareholders. [6 MARKS]