The shareholders of Bighorn Ltd. are unhappy about Sarah's performance (Sarah is the top manager in the company). While Sarah's effort in running the firm cannot be observed, it is felt that she only puts in effort amounting to about 40 hours a week. Her annual salary at present is $240,000.

A new incentive contract is being considered by the shareholders, whereby Sarah would receive a salary of $150,000 per annum plus a bonus of 25% of reported net income before salary and bonus.

You are asked to analyze the expected impact of the new bonus plan on Sarah. You estimate that if she puts in about 60 hours per week, net income before manager remuneration will be $1,560,000 per annum with probability of 0.7, and $135,000 per year with probability of 0.3. Under the present salary-based remuneration (with Sarah working only 40 hours per week), your analysis of past income levels shows that annual net income has been $1,560,000 with probability of only 0.1 and $135,000 with probability of 0.9.

You also ascertain that Sarah's utility is equal to the square root of the money she receives, and that disutility for effort is three times the number of hours worked per week. Required

a) Show calculations to verify that, under the present compensation plan, Sarah will prefer to work 40 hours per week over 60 hours.

b) Will Sarah's effort change under the new incentive contract? Show calculations and explain.

c) A new accounting standard is proposed that, while it will not change future expected net income, will greatly increase the volatility (i.e., reduce the precision) of net income. Explain why Sarah would likely object to the proposed new standard.