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Managerial Economics: Applications, Strategy and Tactics 12th Edition by James McGuigan, Charles Moyer, Frederick Harris
Edition 12ISBN: 9781439079232Managerial Economics: Applications, Strategy and Tactics 12th Edition by James McGuigan, Charles Moyer, Frederick Harris
Edition 12ISBN: 9781439079232 Exercise 1
Should Hydro as an aluminum producer invest in wind power in light of the Utsira pilot project Why or why not
Explanation
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If shareholders decide to pay 1 percent bonus of the $240 million as a cash bonus, then they should pay $2.4 million to the CEO. However, this bonus is conditioned upon the attainment of a certain performance level.
The performance level at which the bonus will be triggered when the initial share price of $65 rises to $80. When the share price rises to $80, then the total shareholders value will be
. At this level of shareholder's value it might be that CEO is putting in low effort but the nature of the world is Good Luck.
Yes, the shareholder's value will rise to $800,000,000 (or $800 million) if shareholders decide to pay a bonus of $2.4 million to motivate CEO to put in high effort but the nature of the world is medium luck.
The main criticism of this incentive contract plan is that it is difficult to distinguish effort of the CEO and Luck. This is because of moral hazard problem that occurs when there exists asymmetry in information. It can be seen that due to moral hazard problem, CEO could get bonus 30 percent of the time even if he puts Low effort. However, he only gets a bonus 70 percent of the time if he puts in High effort. That is the difference in the expected bonus due to moral hazard problem is
which is still greater than the personal opportunity cost of $200,000.
Hence, compensation committee may elicit High effort or may not elicit High effort with this incentive contract.
The performance level at which the bonus will be triggered when the initial share price of $65 rises to $80. When the share price rises to $80, then the total shareholders value will be
. At this level of shareholder's value it might be that CEO is putting in low effort but the nature of the world is Good Luck.Yes, the shareholder's value will rise to $800,000,000 (or $800 million) if shareholders decide to pay a bonus of $2.4 million to motivate CEO to put in high effort but the nature of the world is medium luck.
The main criticism of this incentive contract plan is that it is difficult to distinguish effort of the CEO and Luck. This is because of moral hazard problem that occurs when there exists asymmetry in information. It can be seen that due to moral hazard problem, CEO could get bonus 30 percent of the time even if he puts Low effort. However, he only gets a bonus 70 percent of the time if he puts in High effort. That is the difference in the expected bonus due to moral hazard problem is
which is still greater than the personal opportunity cost of $200,000.Hence, compensation committee may elicit High effort or may not elicit High effort with this incentive contract.
Managerial Economics: Applications, Strategy and Tactics 12th Edition by James McGuigan, Charles Moyer, Frederick Harris
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