Tom operates a small, fast-growing electronics business. His workload has expanded to the point where he decides to hire a full-time manager so that he can concentrate on the technical aspects of the business.

Tom is negotiating with Lily for the manager He ascertains that Lily risk averse.

with utility for money equal to the square root of the dollar compensation received.

Lily advises Tom that she already has a job offer, which yields her an expected utility of 6.

She is not willing to work for less than this, but would accept an expected utility of 6 from Tom. Lily also advises that she is effort-averse, with disutility of effort of 2 if she works hard, and 1 if she does not work hard.

Tom’s business has, in previous years, earned net income (before manager compensation)

of $725 75% of the time, and income of $0 25% of the time. Tom has always worked hard (a1), and reckons that if he did not work hard net income would have been $725 only 20% of the time and zero for 80% of the time. He expects this earnings pattern to continue into the future with a new manager. Tom realizes that he must motivate Lily to work hard, and offers her compensation based on a proportion of reported net income before manager compensation.

Required

a. What proportion of net income must Tom offer Lily so that she will accept the position and work hard? Show calculations.

b. Assuming that Lily accepts Tom’s offer, verify that she will in fact work hard.

c. Having accepted the position, Lily soon realizes that she can opportunistically manage earnings so as to ensure that net income of $725 is reported, even if she does not work hard. Calculate whether or not, in a one-year contract, Lily is better off to work hard and not manage earnings or to not work hard and manage earnings. |

d. State and explain two reasons why a manager who may be tempted to not work hard and cover up by opportunistic earnings management would not do so.