The shareholders of X Ltd. will vote at the forthcoming annual meeting on a proposal to establish a bonus plan for X Ltd. management, based on firm earnings. Proponents of the plan argue that management will work harder under a bonus plan and that future cash flows will thereby increase. However, a dissident shareholder group argues that there is little point in granting a bonus plan, because management will bias or otherwise manage earnings to increase their bonus, rather than working harder.
Upon investigation, you estimate that if the bonus plan is granted, expected future cash flows will be $ 150 if management does not manage earnings, and $ 140 if it does, before management remuneration in each case ( cash flows are lower in the latter case because, rather than working harder, management uses earnings management to disguise shirking). Management remuneration, including the bonus, would be $ 50 if it does not manage earnings and $ 60 if it does. Assume that cash flows not paid as management remuneration will go to the shareholders. If the bonus plan is not granted, expected cash flows will be $ 140 before management remuneration if management does not manage earnings and $ 100 if it does. Management remuneration would be $ 30 in either case, with the balance of cash flows going to the shareholders.

a. Prepare a payoff table for the above game between shareholders and management.
b. Which strategy pair will be chosen? That is, identify a Nash equilibrium for the game. Assume both players are risk neutral.
c. What is the main advantage of a game theory approach to modelling the management’s decision whether to manage earnings, rather than modelling it as a single-person decision theory problem of the manager?

  • CreatedSeptember 09, 2014
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