The owner of a medium- size electronics company is concerned about cash flow. The company operates in a growing industry and produces a product that is in high demand. The owner feels that cash flow should be higher than it has been lately and fears that the company manager may be shirking, despite receiving a generous salary.
Company shares are all held by the owner and are not traded. However, at the bank’s insistence, audited financial statements are prepared annually in accordance with GAAP.
The owner has decided to replace the current manager and to hire a new manager under a one- year contract, with compensation paid at the end of the year. You are hired to recommend a contract that will align the manager’s interests with those of the owner.
Upon reviewing the company’s history of past performance, you determine that if the manager works hard (a1), cash flows of $ 600 are generated with probability 0.7 and $ 200 with probability 0.3. If the manager shirks (a2), the probability of $ 600 cash flow falls to 0.3, with the probability of $ 200 rising to 0.7.
You also note that while these cash flows result from the manager’s effort during the year, they are not fully received until the end of the following year. This is because the company conducts R& D, and also incurs risks of legal liability, which do not fully pay off and come due for some time.
Your study of past financial statements reveals that net income is a noisy predictor of cash flows. Specifically, if cash flows are going to be $ 600, then net income for the year before any manager compensation is $ 725 with probability 0.8 and $ 100 with probability 0.2. If cash flows are going to be $ 200, net income for the year is $ 725 with probability 0.16 and $ 100 with probability 0.84. This is because of recognition lag given the complex nature of R& D and legal liability, it is not possible to report a net income that perfectly predicts future cash flows.
You interview a prospective manager, and find that her reservation utility is 5. Also, she is risk averse, with utility of compensation equal to the square root of the dollar amount of compensation received. She is also effort averse, with disutility of effort of 2 units of utility if she works hard and 1 unit of utility if she shirks.
a. You decide to recommend a compensation contract based on a percentage of audited annual net income before manager compensation. What percentage of net income should you recommend? Show calculations.
b. Why did you decide that net income should be audited to serve as a basis for payment of compensation?
c. Based on the percentage of net income that you recommend, verify that the manager will receive reservation utility and work hard. Show calculations.
d. Suppose that improvements to GAAP reduce the noise in net income, as follows. If cash flows are going to be $ 600, net income for the year is $ 650 with probability 0.9 and $ 150 with probability 0.1. If cash flows are going to be $ 200, net income for the year is $ 650 with probability 0.1 and $ 150 with probability 0.9. Will your recommended percentage of net income be higher or lower than the percentage you recommended in part a? Explain why. Calculations are not required.