- Read the Case Exercise Designing a Managerial Incentive Contract (p. 628 of the Textbook) - Answer the following questions: 1. What is the maximum amount it would be worth to shareholders to elicit high CEO effort all the time rather low CEO effort all the time? 2. If you decide to pay 1% of this amount (in Question 1) as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high CEO effort when and if medium luck occurs by paying the bonus for $800 million outcomes. What criticism can you see with this incentive contract plan? 3. Suppose you decide to elicit high CEO effort when and if bad luck occurs by paying the bonus for $1 billion outcomes only. What criticism can you see with this incentive contract plan? 4. Suppose you decide to elicit high CEO effort when and if bad luck occurs by paying the bonus for $500 million outcomes. What criticism can you see with this incentive contract plan?

\fDESIGHNING A MANAGERIAL INCENTIVE CONTRACT 1. Maximum Amount it would be worth to shareholders to elicit High CEO effort all the time can be calculated as under: Luck Amount Probability Product ($ in million) (B) (A x B) (A) Good 1000 0.3 300 Medium 800 0.4 320 Bad 500 0.3 150 Total 1 770 Hence, $ 770 miilion is the maximum amount. 2. Cash Bonus = $ 770 miilion x 1% = $ 7.7 million The Performance levels which can be triggered are a) Good Luck and Low CEO efforts b) Medium Luck and High CEO efforts Suppose High CEO efforts with medium luck are triggered, then this can be criticised on the following grounds: a) Efforts cannot be quantified. b) Presence of other scenarios having same performance level. c) Luck cannot be measured. 3. Being a member of compensation committee, I would like to criticise the policy on following grounds: a) The committee is cannot judge the three states of luck b) Efforts cannot be quantified or measured. c) Benefit are not mainly because of the efforts of individual d) Quality is often compromised 4. Being a member of compensation committee, I would like to criticise the policy on following grounds: a) Incentives are given even in case of Bad Luck b) The committee is cannot judge the three states of luck c) Efforts cannot be quantified or measured. 5. The Shares Price can be ranged between $ 30 to $100. If the Share Price is identified at the $30 per share (Bad Luck + Low CEO Effort), in this case, the CEO's bonus will be the lowest. However, if the share Price is identified at $ 100 (Good Luck + High CEO Effort), the bonus payout will be the highest. So, as to maximize, shareholder's value and at the same time triggering the payment bonus, the share price should be recognised between $30 and $100. Payment to auditor is a statutory liability and will be paid accordingly. It would be decided in accordance with the work done by the auditor, and can be calculated as a percentage of shareholders fund value. Such payment is made before managerial remuneration