Consider the following simple corporate example involving one stockholder and one manager. There are two mutually exclusive projects in which the manager may invest and two possible manager compensation plans that the stockholder may choose to employ. The manager may be paid a flat $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:

a. Which project maximizes shareholder wealth? Which compensation plan does the manager prefer if this project is chosen?
b. Which project will the manager choose under a flat compensation arrangement?
c. Which compensation plan aligns the interests of the stockholders and the manager so that the manager will act in the best interest of the stockholders?
d. What do the answers tell you about structuring management pay contracts?

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Project #1 Project #2 Probability 33.33% 33.33% 33.33% Gross Profit $0 $3,000,000 $9,000,000 Probability 50.0% 50.0% Gross Profit $600,000 $900,000