3. Executive compensation. As they meet to discuss next year's terms of employ- ment of their CEO, there is some disappointment among the directors of Salah Inc. Some attribute the mediocre performance of the company to the CEO's habit of taking frequent naps. To keep the company on track, the board wants to incentivize the CEO to exert more effort on the job. Assume the following: . If the CEO exerts low effort (keeps on taking naps), then the company's operating profits are projected to be $60 million If the CEO exerts high effort (stop taking naps), operating profits are pro- jected to be $60 million with probability q = 0.8 and $140 million with probability 1 q. High effort costs the CEO the equivalent of $400,000 in additional compen- sation (you can think of this sum as the CEO's subjective valuation of a year's naps). (a) One board member proposes paying the CEO a flat wage of $2 million. What effort level would the CEO choose in such circumstance? What would be the resulting profits for the company (operating profits net of CEO pay)? (10 points) (b) Another director proposes to pay the CEO by means of a profit-sharing contract. Under this plan, the CEO would be compensated in the measure of 2% of the company's operating profits. What effort level would the CEO choose in this case? What would net profits amount to? (10 points) (C) Now assume that in fact the CEO already has a binding compensation con- tract for the year, which calls for a flat compensation of $800,000. The Board contemplates offering the CEO to replace it with a profit-sharing scheme. What is the minimum share of profits y that the Board needs to offer the CEO in order to incentivize her to exert high effort? What are the company's net profits if the board indeed offers such scheme? (10 points) 3. Executive compensation. As they meet to discuss next year's terms of employ- ment of their CEO, there is some disappointment among the directors of Salah Inc. Some attribute the mediocre performance of the company to the CEO's habit of taking frequent naps. To keep the company on track, the board wants to incentivize the CEO to exert more effort on the job. Assume the following: . If the CEO exerts low effort (keeps on taking naps), then the company's operating profits are projected to be $60 million If the CEO exerts high effort (stop taking naps), operating profits are pro- jected to be $60 million with probability q = 0.8 and $140 million with probability 1 q. High effort costs the CEO the equivalent of $400,000 in additional compen- sation (you can think of this sum as the CEO's subjective valuation of a year's naps). (a) One board member proposes paying the CEO a flat wage of $2 million. What effort level would the CEO choose in such circumstance? What would be the resulting profits for the company (operating profits net of CEO pay)? (10 points) (b) Another director proposes to pay the CEO by means of a profit-sharing contract. Under this plan, the CEO would be compensated in the measure of 2% of the company's operating profits. What effort level would the CEO choose in this case? What would net profits amount to? (10 points) (C) Now assume that in fact the CEO already has a binding compensation con- tract for the year, which calls for a flat compensation of $800,000. The Board contemplates offering the CEO to replace it with a profit-sharing scheme. What is the minimum share of profits y that the Board needs to offer the CEO in order to incentivize her to exert high effort? What are the company's net profits if the board indeed offers such scheme? (10 points)
