Adrienne, a manager of a large firm, must decide whether to launch a new product or make a minor change to an existing product. The new product has a 30% chance of being a big success and generating profits of $20 million, a 40% chance of being fairly successful and generating profits of $5 million, and a 30% chance of being a costly failure and losing $10 million. Making minor changes in the old product would generate profits of $10 million for sure. Adrienne’s contract gives her a bonus of 10% of any profits above $8 million arising from this decision. If Adrienne is risk neutral and cares only about her own income, what is her decision?

Should shareholders be happy with this compensation contract? Is there a contract that would be better for both Adrienne and the shareholders? (Hint:

See Solved Problem 19.4.) M 5. Contract Choice