QUESTION 1 - Dan owns a medium-sized business, which, over the years, has generated some profits. Now he wishes to hire a manager to run the business. From his previous experience, Dan knows that if the manager works hard, there will be a cash flow of $500 with a probability of 70% and a cash flow of $272 with a probability of 30%. On the other hand, if the manager shirks, there will be a cash flow of $500 with a probability of 30% and a cash flow of $272 with a probability of 70%.
Dan knows from previous experience that if cash flows are $500, then net income will be $576 with probability 80% and $196 with probability 20%. On the other hand, if cash flows are $272, then net income will be $576 with probability 20% and $196 with probability 80%.
Dan has interviewed Mira and he feels Mira will be a good candidate for the position of the manager. Mira has square root utility and has disutility of effort of 7 if she works hard and 6 if she shirks. Mira's reservation utility is 3.
Required - Show all calculations for the following questions, except part 6.
1. Calculate what percentage of net income Dan should offer Mira to make her accept this offer.
2. Verify that Mira will work hard when offered this percentage.
3. Having accepted the position, Mira realizes that she can opportunistically manage income so that whatever happens, she can report a net income of any amount not exceeding $576. Predict Mira's reporting behavior and explain whether Mira will work hard or shirk under these circumstances.
4. After 2 years, Dan becomes concerned about Mira's work. He decides to change Mira's compensation contract. He offers her a profit share of 25% if net income is $576 and 73.47% if net income is $196. Explain why Dan offers this compensation. Indicate whether Mira will shirk or work hard under this contract.
5. Dan is risk-neutral, with utility equal to the amount of profit received after manager compensation. Determine whether Dan's expected utility is higher or lower under the new contract in part (4), compared to the original contract in part (1).
6. Provide one solution to help Dan solve the issue in part (3) and motivates Mira to work hard at the same time.
QUESTION 2 - Blackberry reported a total compensation of US$85,753,220 for their CEO John Chen in the period from November 2013 to October 2014. Mr. Chen joined Blackberry in November 2013, and he was granted an award of 13 million time-based Restricted Stock Unites (RSUs) in connection with his appointment as Executive Chair and Interim Chief Executive Officer in November 2013. (13 million is the number of shares, and the value of the shares is US$ 84,773,000.)
25% of these RSUs vest on each of the 3rd and 4th anniversaries of the effective date of his employment agreement, with the remaining 50% vesting on the 5th anniversary. It means he might sell 25% of the shares after he stays in Blackberry for three years if he met all requirements, another 25% after four years, and the rest 50% after five years. Vesting requirements may be met by the passage of time or by either company or individual performance. If Mr. Chen does not meet the requirements the company set forth prior to the end of the vesting period, the units are typically taken back to the company.
This table presents the components of Mr. Chen's compensation:
Required:
1. Discuss whether Mr. Chen is overpaid or not. (Hint: look at the net income/loss reported by Blackberry, and consider the CEO's wealth and the inventors' wealth to answer this question.)
2. Discuss whether it is appropriate for Blackberry to pay 98.856% of the CEO compensation using shares and 1.143% ((326,374 +653,846)/85,753,220) using cash.
3. Based on the current compensation, what earnings management strategy and the tax planning strategy will most likely be used by Mr. Chen and why?
4. Discuss possible one method Blackberry could use to control upside risk of CEO compensation and one method for the downside risk of CEO compensation.
5. Discuss one pros/advantage and one cons/disadvantage of using ESOs.