Course: Accounting theory and policies ACCT725

book: financial accounting theory 7th by Willian R. Scott

Terry is looking for a full-time manager to run his business while he pursues other opportunities.

From past experience, Terry knows that the new manager can put in two levels of effort; a high level of effort (work) or a low level of effort (shirk). If the manager puts in a high level of effort, the company will produce $450 of net income with 0.70 probability and $120 of net income with 0.30 probability. If the manager puts in a low level of effort, the net income will be $450 with 0.20 probability and $120 with 0.80 probability.

Terry has interviewed Jenny for the job and wants to make an offer. He finds out that Jenny has a square root utility function for compensation and has a disutility of effor of 1.5 if she puts in a high level of effort and a disutility of effort of only 10 if she puts in a low level of effort.

Jenny's reservation utility is 5.0.

Terry is considering various compensation packages for Jenny, as detalled below.

Required

a. Terry wants to pay Jenny $30 as a fixed salary plus a bonus that is 5% of net income after the manager's salary (of $30).

i. Calculate Jenny's expected utility based on high effort.

ii. Calculate Jenny's expected utility based on low effort.

iii. Determine if Jenny will accept the package and, if so, if she will put of effort or a low level of effort. in a high level

b. Terry is thinking of an alternative compensation package for Jenny with a fixed salary of $40 and no bonus.

i. Calculate Jenny's expected utility based on high effort

ii. Calculate Jenny's expected utility based on low effort.

iii. Determine whether Jenny will accept the offer, and if so, if she will put in a high level of effort or a low level of effort.