Question

Designing a Managerial Incentives Contract

Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding the personal costs. The CEO and EVPs face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior 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, soon thereafter the good, medium, or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.

	SHAREHOLDER VALUE
	GOOD LUCK (30%)	MEDIUM LUCK (40%)	BAD LUCK (30%)
High Effort	$1,000,000,000	$800,000,000	$500,000,000
Reduced Effort	$800,000,000	$500,000,000	$300,000,000

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 EVPs and CEOs 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 reduced effort and medium luck or high effort and bad luck. Similarly, it is not possible to distinguish reduced effort and good luck from high 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 and EVPs.

Referenced Questions:

• 2. If you decide to pay 1 percent of the increase in shareholder value 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 effort by paying a bonus should the company’s value rise to $800,000,000. What two criticisms can you see of this incentive contract plan?
• 3. Suppose you decide to elicit high effort by paying a bonus only for an increase in the company’s value to $1,000,000,000. When, and if, good luck occurs, what two criticisms can you see of this incentive contract plan?
• 4. Suppose you decide to elicit high effort by paying the bonus when the company’s value falls to $500,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

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#8) 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.

#9) Sketch the game tree for designing this optimal managerial incentive contract among the alternatives in Question 2, 3 and 4. Who makes the first choice? Who the second? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the Compensation Committee of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in Questions 7 and 8?

Answer 1

2. Incentive bonus : 1% of 770,000,000 =77,000,000. The value of shareholders $800,000,000 is one of the reason for bonus.

The first criticism is, as share holder value of $800,000,000 would be possible even with good luck and reduced effort. Bonous can be paid even when there is a reduced effort. The incentive also does not generate high effort and also rewards the reduced effort.

second criticism is,if the managers looks into bad luck unfold, they think that value of shareholder value would be either $500,000,000 or $300,000,000. In such case managers doesnot put much effort on it because they would not receive bonus whether they put higher efforts or not. Hence bonus does not achieve its objective as it doesnot reward the high level of effort from managers

3. F irst criticism is,if the managers looks into bad luck unfold, they think that value of shareholder value would be either $500,000,000 or $300,000,000. In such case managers doesnot put much effort on it because they would not receive bonus whether they put higher efforts or not. Hence bonus does not achieve its objective as it doesnot reward the high level of effort from managers.

second criticism is The second criticism is that value of shareholder for bonus is too high at $1,000,000,000

4.As there is no better alternative for managers other than putting high efforts to achieve the value of shareholder $500,000,000 to get the bonus, so managers when they see bad luck unfolds they put always higher efforts

8. The company can raise $8,000,000 through good luck and reduced efforts or medium luck with higher efforts. if the shareholder decided to pay only for higher efforts, good luck may not be recognzied but good luck also contributes to the increase in share holder value