High CEO Effort $1,000,000,000 $800,000,000 $500,000,000
Low CEO Effort $800,000,000 $500,000,000 $300,000,000
Assume 10 million shares and a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the CEO'S effort and the company luck are unoberservable to the owners and company directors, it is not possible upon observing reduction to $50 share prices and $500,000,000 value to disyinguish whether the company experienced low CEO effort and medium luck or high CEO effort and bad luck. Answer from the perspective of a member of the Compensation Board of Director who is aligned with shareholder interests and is deciding on bonus plans for the CEO
1. What is the maximum amount it would be worth to shareholders to elicit high CEO effort all the time rather low CEO effort all the time?
2. If you decide to pay 1% of this amount (in Question 1) as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high CEO effort when and if medium luck occurs by paying the bonus for $800 million outcomes. What criticism can you see with this incentive contract plan?
3. Suppose you decide to elicit high CEO effort when and if good luck occurs by paying the bonus for $1 billion outcomes only. What criticism can you see with this incentive contract plan?
4. Suppose you decide to elicit high CEO effort when and if bad luck occurs by paying the bonus for $500 million outcomes. What criticism can you see with this incentive contract plan?
5. 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.