Question
Suppose a CEO has a R&D investment opportunity that requires an initial $1 million cash outlay (that is, a $1 million reduction in current pretax
Suppose a CEO has a R&D investment opportunity that requires an initial $1 million cash outlay (that is, a $1 million reduction in current pretax income), but that will produce $2 million in pretax earnings in the future. (Assume the future is "not so distant" such that this project is NPV >> 0 from the standpoint of the firm.) Discuss whether the following compensation arrangements will provide incentives for the CEO to make the investment (assuming in all cases that the CEO will still be in office when the payoffs from the investment are realized).
- The CEO receives a (positive or negative) bonus equal to 10% of pretax income relative to target pretax income, where the "target" is set by the Board of Directors at the beginning of the year based upon expected performance during the year.
- The CEO receives a (positive or negative) bonus equal to 10% of pretax income relative to prior-year pretax income.
- The CEO receives a (positive or negative) bonus equal to 10% of pretax income in excess of $10 million.
- The CEO receives a (positive or negative) bonus equal to 10% of the change in the value of the firm's equity, assuming that stock prices are strong-form efficient.
- The CEO receives a (positive or negative) bonus equal to 10% of the change in the value of the firm's equity, assuming that stock prices are semi-strong-form efficient.
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