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The Quantum Division of Nextel Corp., based in San Jose, California, manufactures semiconductors that convert analogue signals to digital signals. Lynn Kraft is the division manager. Her compensation consists of a base wage of $50,000 plus a bonus of 2 percent of division profits above $10 million. Last year's division profits were $12 million, and so Kraft received a bonus of $40,000.

This year two things happened that adversely affected division profits. First, the price of gold, a key ingredient in Quantum's chips, increased dramatically, causing the division's costs to be higher than expected. Second, an earthquake in the San Jose area caused Quantum's plant to be closed for 6 weeks and to require $1 million in repairs. Division profits for this year were $9 million.

Kraft believes her compensation plan should be adjusted for these events. She believes that, but for these events, division profits would have been $13 million for the year.

a. What issues should the CEO of Nextel consider when deciding whether to adjust Kraft's bonus plan? Do you think the plan should be adjusted? Why?

b. Why might it be value increasing for the firm to make Kraft accountable for such events?

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