DESIGNING A MANAGERIAL INCENTIVES CONTRACT

Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO. The CEO can either work really hard with a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or she can reduce her effort, thereby avoiding the personal costs. The CEO faces three possible outcomes: the probability of her company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. 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. Once the board designs an incentive contract, the CEO decides to expend high or low work effort, and soon thereafter the good, medium, or bad luck occurs. One of the observable shareholder values listed below then results.

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 CEO's 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 low CEO effort and medium luck or high CEO effort and bad luck. Similarly, it is not possible to distinguish low CEO effort and good luck from high CEO 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

Questions

1. What is the maximum amount it would be worth to shareholders to elicit high CEO effort all of the time rather than low CEO effort all of the time?

2. If you decide to pay 1 percent of this amount (in 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 a bonus should the company's value rise to $800,000,000. 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 a bonus only for an increase in the company's value to $1,000,000,000. 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 when the company's value falls to $500,000. What criticism can you see of this incentive contract plan?

5. In an effort to identify the share price that should trigger a bonus, the payment for the CEO, and maximize shareholder value, how much would you, the Compensation Committee, be willing to pay an auditor to examine the expense and revenue flows in real time and deliver perfect forecasting information about the "luck" the firm is experiencing? Compare shareholder value with this perfect information relative to the best choice among the cash bonus plans in Questions 2, 3, and 4.

6. Design a stock option-based incentive plan to elicit high effort. Show that 1 million stock options at a $70 exercise price improves shareholder value relative to the best of the cash bonus plans in Questions 2, 3, or 4.

7. 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.

8. Financial 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. What's the maximum amount the Compensation Committee of the board will be willing to pay for a perfect forecast if it were possible for the auditors to distinguish good from medium luck? What about medium from bad luck?