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Question: Specific Electric Co. asks you to implement

Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding the personal costs. The CEO and EVPs face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three “states” of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium, or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.
Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding the personal costs. The CEO and EVPs face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three “states” of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium, or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results. 


Assume the company has 10 million shares outstanding offered at a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVPs and CEOs effort and the company’s luck are unobservable to the owners and company directors, it is not possible when the company’s share price falls to $50 and the company’s value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or high effort and bad luck.
Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one-half million shares granted at $70 improves shareholder value relative to all prior alternatives.

Assume the company has 10 million shares outstanding offered at a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVPs and CEOs effort and the company’s luck are unobservable to the owners and company directors, it is not possible when the company’s share price falls to $50 and the company’s value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or high effort and bad luck. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one-half million shares granted at $70 improves shareholder value relative to all prior alternatives.





Transcribed Image Text:

Shareholder Value GOOD LUCK MEDIUM LUCK BAD LUCK (30%) (40%) (30%) High Effort $1,000,000,000 $800,000,000 $500,000,000 Reduced Effort $ 800,000,000 $500,000,000 $300,000,000


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> Despite a decade of subsidies and considerable success in Denmark, Germany, and Britain, renewable energy in the U.S. accounts for only 7 to 8 percent of total energy consumption. Hydroelectric power remains the most successful source of renewable energy

> Despite a decade of subsidies and considerable success in Denmark, Germany, and Britain, renewable energy in the U.S. accounts for only 7 to 8 percent of total energy consumption. Hydroelectric power remains the most successful source of renewable energy

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> Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in

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> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> The setting is a Ralph Lauren outlet store, and the product line is Polo golf shirts. A product manager and the General Manager for Outlet Sales are analyzing the discounted price to be offered at the outlet stores. Let’s work through t

> Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in

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