PLEASE ANSWER QUESTION 9 ONLY

1. What is the maximum amount it would be worth to shareholders to elicit high effort all of the time rather than reduced effort all of the time?

$240 million

2. If you decide to pay 1 percent of the increase in shareholder value as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high effort by paying a bonus should the companys value rise to $800,000,000. What two criticisms can you see of this incentive contract plan?

There should only be a bonus pay out at high efforts and a share price of $100. This would reward the managers hard work and high efforts as well as making the most out of the luck given.

One issue with giving a bonus at $800,000,000 is that it is hard to determine whether this was the result of good luck and bad effort or high effort and medium luck. This can cause a discrepancy in the planning for the company. The second issue is with there being a discrepancy in knowing whether or not it was a result of luck or effort the company could reward their managers with a bonus for reduced effort assuming they had good work.

3. Suppose you decide to elicit high effort by paying a bonus only for an increase in the companys value to $1,000,000,000. When, and if, good luck occurs, what two criticisms can you see of this incentive contract plan?

The first issue is that a plan like this can incite workers to take unwarranted risks in an effort to raise the company's value. This is due to the fact that employees would be driven to take whatever steps are required to attain the $1,000,000,000 goal, whether or not such steps are in the company's best interests. Because of this, workers could end up making dangerous choices that could endanger the company's long-term viability in an effort to make a quick profit.

The second issue is that this plan would incentivize workers to prioritize short-term rewards over long-term development. This is due to the fact that employees would only be encouraged to perform measures that would result in an instantaneous rise in the company's value because the bonus wouldn't be paid out until the company's value hit $1,000,000,000. Due to their concentration on reaching a short-term objective rather than establishing the company for the future, employees may make choices that are not in the best interests of the company's long-term success.

4. Suppose you decide to elicit high effort by paying the bonus when the companys value falls to $500,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

The problem with this scenario is that it's unclear if there was good effort and terrible luck or good effort and average luck. With that being said, it is also unclear if a bonus should be awarded considering that corporate employees may have put in less effort yet had average luck instead.

However, as it is unknown which direction took place, a bonus could still be awarded. The issue is that rewarding such people when they shouldn't be rewarded defeats the purpose of rewarding the bonus for great work when decreased effort may have occurred.

5. If the bonus compensation scheme must be announced in advance, and if you must pick one of the three choices in Questions 2, 3 and 4, which one would you pick and why? In other words, under incomplete information, what is the optimal decision by the Boards Compensation Committee dedicated to act in the shareholders interest?

It appears the most optimal incentive plan to elicit high effort is to pay the bonus when the shareholder value rises to $800 million. Luck cannot be distinguished so applying the bonus to the moderate state offers the less risk, and could also increase the shareholder value. Keeping the shareholders interest as a priority, this is the optimal decision.

6. Audits are basically sampling procedures to verify with a predetermined accuracy the sources and uses of the company receipts and expenditures; the larger the sample, the higher the accuracy. In an effort to identify the share price that should trigger a bonus, how much would you, the Compensation Committee, be willing to pay an auditing consultant who could sample the expense and revenue flows in real time and deliver perfect forecasting information about the luck the firms sales force is experiencing? Compare shareholder value with this perfect forecast information relative to the best choice among the bonus plans you selected in Question 5. Define the difference as the Potential Value of Perfect Forecast Information.

The expected value with perfect information is $240 million [(200,000 x .30) + (300,000 x .40) + (200,000 x .30)] Using the bonus plan to be paid at $800 million, the maximum expected value with incomplete information is $120 million (300,000 x .40). The potential value of perfect forecast information is the expected value of perfect information minus the expected value with incomplete of information would equal $120,000 ($240 million - $120 million), thus this would be what the committee would be willing to pay for an auditing consultant to deliver perfect forecasting information.

7. Design a stock option-based incentive plan to elicit high effort. Show that one million stock options at a $70 exercise price improve shareholder value relative to the best of the cash bonus plans chosen in Question 5.

$167 million

8. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one-half million shares granted at $70 improves shareholder value relative to all prior alternatives.

$205 million

9.Sketch the game tree for designing this optimal managerial incentive contract among the alternatives in Question 2, 3 and 4. Who makes the first choice? Who the second? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the Compensation Committee of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in Questions 7 and 8?