Question1: Today is t = 0. You are given the information below: Firm F is all equity financed with 100 shares outstanding Firm F will generate a single cash flow at t = 1 that can be high (1,000) or low (500) Cash flow is high if the CEO uses all the firms resources to create value If the CEO diverts the firms resources, the cash flow is low, but the CEO enjoys a private benefit that has a value of 40 The CEO compensation is composed of: 10 oneyear stock options, where the strike price is 15 The payoff on each option is simply: max(S1 15, 0), where S 1 is the stock price at t = 1 Firm F also owns gold with a current total market value of 1,000. Gold prices are equally likely to go up or down by 25% at t = 1, and this is out of the control of the CEO

a) What resource allocation will the CEO choose, use all resources or divert firm resources?

b) Suppose that F hedged its gold price exposure by shorting a one-year forward contract on gold at t = 0, where the t = 1 sale price is locked in at a value of 1,000, regardless of what actually happens to the price of gold at t = 1. What resource allocation will the CEO choose, use all resources or divert firm resources? c) If it were up to the CEO, would the CEO want the firm to hedge or not? d) If it were up to shareholders to decide, would they want the firm to hedge or not?