The shareholders of x Ltd. are unhappy about the top manager's performance. While the manager's effort in running the firm cannot be observed, it is felt that he or she puts in effort amounting to about 40 hours a week. The manager's annual salary at present is $160,000.

A new incentive contract is being considered by the shareholders, whereby the manager would receive a salary of $100,000 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 the manager. You estimate that if the manager puts in about 60 hours per week (a1), net income before manager remuneration will be $1,040,000 per annum with probability of 0.7, and $90,000 per year with probability of 0.3. Under the present salary-based remuneration, whereby the manager's effort is 40 hours per week (a2), analysis of past profitability shows that annual net income has been $1,040,000 with probability of only 0.1 and $90,000 with probability of 0.9.

You also ascertain that the manager's utility for money is equal to the square root of the money received, and that disutility for effort is four times the number of hours worked per week.

Required

a.Show calculations to verify that, under the present salary-based remuneration plan, the manager will prefer to work 40 hours per week over 60 hours.

b.Which act, a1 or a2, will the manager prefer under the new incentive contract? Show calculations.

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 the manager would object to the proposed new standard.