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Specific Electric Co asks you to implement a pay for performance incentive contract for its new CEO.
Specific Electric Co asks you to implement a pay for performance incentive contract for its new CEO. The CEO can either work hard with a personal opportunity cost of $200,000 or reduce her effort, thereby avoiding the personal cost. The CEO faces three possible outcomes: the probability of her company experiencing good luck is 30 percent, medium luck, 40 percent and bad luck, 30 percent. Although the management team can distinguish the three “states” of luck as the quarter unfolds, the Compensation Subcommittee of the Board of Directors (and the shareholders) cannot do so. Sometime thereafter, the CEO decides to expend high or low work effort, and one of the following observable shareholder values then results: Shareholder Value (in millions)Good Luck (30%)Medium Luck (40%)Bad Luck (30%)High CEO Effort$1,000$800$500Low CEO Effort$800$500$300Assume the company has 10 million shares outstanding offered at a $65 initial share price, implying a $650 million initial shareholder value. Because the CEO’s 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 million to distinguish whether the company experienced low CEO effort and medium luck or high CEO effort and bad luck. Similarly, it is not possible to distinguish low CEO effort and good luck from high CEO effort and medium luck.Answer the following questions from the perspective of a member of the Compensation Committee of the Board of Directors who is aligned with the shareholders’ interests and is deciding on bonus plans for the CEO.1-Suppose you decide to elicit high CEO effort when and if good luck occurs by paying a bonus only for an increase in the company’s value to $1 billion. What criticism of this incentive contract plan can you see?
