Designing a Managerial Incentives Contract

1421 Words Dec 3rd, 2011 6 Pages
Question1:

High CEO Effort;
Expected shareholders’ value = $1,000,000,000(0.3) + $800,000,000(0.4) + $500,000,000(0.3) = $770,000,000

Low CEO Effort;
Expected shareholders’ value = $800,000,000(0.3) + $500,000,000(0.4) + $300,000,000(0.3) = $530,000,000

Improved shareholders’ value due to high CEO effort;
Amount worth to shareholder for high CEO = $770,000,000 - $530,000,000 = $240,000,000

Question 2:

Payment of bonus should be based on 1% of the improvement from high CEO effort
Bonus to CEO = $240,000,000 X 1% = $2,400,000

To ensure highest shareholders’ value, the performance level triggering this bonus should be $1,000,000,000
The price per share = $1,000,000,000 / 10,000,000
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b) The CEO has the ability to directly or indirectly control the exposure of the company to the luck experienced. For example, although the industry is experiencing good luck, but due to the company directions taken by CEO, the company might just experience medium luck only.
c) It is difficult to predict the expected shareholder value based on luck. For example, during the good luck, the company might have a potential to generate a higher shareholder value but since the target of $1,000,000,000 already achieved, the CEO might reduce the efforts or postpone the opportunity to next year.

Question 4:

Elicit high CEO effort, if or when bad luck occurs, pay bonus when shareholders’ value > $500,000,000:
Criticisms:
a) It is difficult to distinguish whether the company is experiencing high CEO effort with bad luck or the company is experiencing low CEO effort with medium luck of the company as both have the same shareholder value.
b) The effort of the CEO is immeasurable and the luck of the company is difficult to measure.
c) The CEO has the ability to directly or indirectly control the exposure of the company to the luck experienced. For example, although the industry is experiencing medium luck, but due to the company directions taken by CEO, the company might just experience bad luck.
d) It is difficult to predict the expected shareholder value based on luck. For example, during the bad luck, the company might have a potential to generate

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