Question

Designing a Managerial Incentives Contract Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70-hour weeks at a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding the personal costs. The CEO and EVPs face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three “states” of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium, or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.

SHAREHOLDER VALUE
	Good luck (30%)	Medium Luck (30%)	Bad Luck (30%)
High Effort	$1,000,000,000	$800,000,000	$500,000,000
Reduced Effort	$800,000,000	%500,000,000	$300,000,000

Assume the company has 10 million shares outstanding offered at a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVPs and CEOs effort and the company’s luck are unobservable to the owners and company directors, it is not possible when the company’s share price falls to $50 and the company’s value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or high effort and bad luck. Similarly, it is not possible to distinguish reduced effort and good luck from high effort and medium luck. Answer the following questions from the perspective of a member of the Compensation Committee of the board of directors who is aligned with shareholders’ interests and is deciding on a performance-based pay plan (an “incentive contract”) for the CEO and EVPs.

1. Audits are basically sampling procedures to verify with a predetermined accuracy the sources and uses of the company receipts and expenditures; the larger the sample, the higher the accuracy. In an effort to identify the share price that should trigger a bonus, how much would you, the Compensation Committee, be willing to pay an auditing consultant who could sample the expense and revenue flows in real time and deliver perfect forecasting information about the “luck” the firm’s sales force is experiencing? Compare shareholder value with this perfect forecast information relative to the best choice among the bonus plans you selected in Question 5. Define the difference as the Potential Value of Perfect Forecast Information.

2. Design a stock option-based incentive plan to elicit high effort. Show that one million stock options at a $70 exercise price improve shareholder value relative to the best of the cash bonus plans chosen in Question 5.

3. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one-half million shares granted at $70 improves shareholder value relative to all prior alternatives.

4. Sketch the game tree for designing this optimal managerial incentive contract among the alternatives in question 2, 3, and 4. Who makes the first choice? Who the second? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the Compensation Committee of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in Questions 1–8?

Answer 1

-) Selu-dion"- Slep :L Ihe piaximum A meent fo shareholders for high e f-forels all «the dime is $2410 million.ficm the Shave heledeis inlue dable, manager erlorls are he fieved at $ cone mfillion prant, the I percent CF $ 210 Milliern i.e 2.4 million (=C99uomillion xl:/ (Saio mfllicn xo.c1)= ¢ 2.4 millien) ececuld be >) Paid at the maximUm high efferd value i.e $ billion. slep 2 the company ualue Can ri se to $ 800,000,0cto thyough Gecol luck and recluced effort (or) medieim luck and high efords. if the shaveholbler decides to pay the bonus For only high effordS. dhen the Gocdl (uck & reduced effends. worit be reccgniseel but dhis is also orlidy contribautes do the incveasing cempany's value.