Growth Ltd. is a high- tech firm whose owner does not have the required management expertise to run the firm.
Growth Ltd. is a high- tech firm whose owner does not have the required management expertise to run the firm. The owner wants to hire a manager with the required expertise. The continued success of Growth Ltd. depends crucially on how hard the new manager works.
If the manager works hard (a1), firm net income will be $ 500 with probability 0.7 and $ 200 with probability 0.3. If the manager shirks (a2), net income will be $ 500 with probability 0.2 and $ 200 with probability 0.8. In both cases, profits are before manager compensation.
The owner is interviewing a prospective manager, and finds out that she is risk averse, with utility for compensation equal to the square root of the dollar compensation received. Like most people, however, she is also effort averse. If she works hard, she suffers a disutility of effort of 2 units of utility. If she shirks, her effort disutility is zero.
a. Growth Ltd. offers the manager a one- period contract with a salary of $ 41 per period plus 20% of net income before manager compensation. If she accepts the job, will the manager take a1 or a2? Show your calculations.
b. Instead, Growth offers the manager zero salary plus 30% of net income before man-ager compensation. Assuming the manager accepts, will she take a 1 or a 2? Show your calculations.
c. Does the manager’s effort decision change between parts a and b above? Explain why or why not.
d. Many executive compensation contracts base the manager’s compensation on both net income and share price performance. Explain an advantage of using two performance measures rather than one in compensation contracts.
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