Consider a firm where the effort undertaken by managers can affect cash flows in the next period. For simplicity, assume managers either exert low effort or high effort. Assume that investors cannot observe effort.
a) Assume that, with low effort, the firm realizes XL with certainty and, with high effort, the firm realizes XH with certainty. If cash flows can be observed by investors, is there asymmetric information between investors and managers? Explain.
b) Now assume that, with low effort, the firm earns XL with probability q and XH with probability (1-q). With high effort, the firm realizes XL with probability p and XH with probability (1-p). If q > p, is there asymmetric information between investors and managers? If so, is it hidden information or hidden action? Explain.
c) Would managerial compensation in the form of stock options raise the value of the firm? Explain.
d) Assume that in bankruptcy, the managers are dismissed without collecting bonuses. Assume no taxes or costs of bankruptcy. Would higher levels of debt raise the value of the firm? Explain.