Specific Electric Co. asks you to implement a pay for performance incentive contract for its new CEO. The CEO can either work hard with a personal cost of $200,000 or reduce her effort, thereby avoiding the personal cost. The CEO faces three possible outcomes: her company experiences good luck with probability 0.3, medium luck with probability 0.4, or bad luck with probability 0.3. Although the 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. Sometime thereafter, the CEO decides to expend high or low work effort, and one of the observable shareholder values then results.Shareholder ValueGood Luck (30%)Medium Luck (40%)Bad Luck (30%)High CEO Effort$1 billion$800 million$500 millionLow CEO Effort$800 million$500 million$300 millionAssume 10 million shares and a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the CEO’S effort and the Company’s luck are unobservable to the owners and company directors, it is not possible upon observing a reduction to $50 share prices and $500,000,000 value to distinguish whether the company experienced low CEO effort and medium luck, or high CEO effort and bad luck.Answer the following questions from the perspective of a member of the compensation committee who is aligned with shareholder interests and is deciding on bonus plans for the CEO.Questions1)What is the maximum amount it would be worth to shareholders to elicit high CEO effort all the time rather than low CEO effort all the time?2)If you decide to pay 1% of this amount (Question 1) as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high CEO effort when and if medium luck occurs by paying the bonus for $800 million outcomes. What criticism can you see of this incentive contract plan?3)Suppose you decide to elicit high CEO effort when and if good luck occurs by paying the bonus for $1,000,000,000 outcomes only. What criticism can you see of this incentive contract plan?4)Suppose you decide to elicit high CEO effort when and if bad luck occurs by paying the bonus for $500 million outcomes. What criticism can you see of this incentive contract plan?5.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.




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