Consider the following simple corporate example with one stockholder and one manager. There are two mutually exclusive projects in which the manager may invest and two possible manager compensation contracts that the stockholder may choose to employ. The manager may be paid a fl at $300,000 or receive 10 percent of corporate profits.
The stockholder receives all profits net of manager compensation. The probabilities and associated gross profits associated with each project are given below:
Project 1
|
Project 2 |
|
Probability
|
Gross Profit
|
Probability
|
Gross Profit
|
|
33.33%
|
$0
|
50.0%
|
$600,000
|
| 33.33% |
$3,000,000 |
50.0% |
$900,000 |
| 33.33% |
$9,000,000 |
|
|
a. Which project maximizes shareholder wealth? Which compensation contract does the manager prefer if this project is chosen?
b. Which project will the manager choose under a flat compensation arrangement?
c. Which compensation contract aligns the interests of the stockholder and the manager so that the manager will act in the best interest of the stockholder?
d. What does this tell you about the structure of management pay contracts?