1. Suppose the marginal benefit of writing a contract is $100, independent of its length. Find the optimal contract length when the marginal cost of writing acontract of length L is:
a. MC(L) ! 30 " 4L.
b. MC(L) ! 40 " 5L.
c. What happens to the optimal contract length when the marginal cost of writing a contract declines?
a. WhenMC(L) = 30 + 4L, the optimal contract lengths sets this equal to the marginal benefit of $100, yielding L = 17.5.
b. When MC(L) = 40 + 5L , the optimal contract length sets this equal to the marginal benefit of $100, yielding L = 12.
c. When the marginal cost curve increases, the optimal contract length increases. When the marginal cost curve decreases, the optimal contract length decreases.
2. The manager of your company's pension fund is compensated based entirelyon fund performance; he earned over $1.2 million last year. As a result, thefund is contemplating a proposal to cap the compensation of fund managers at$100,000. Provide an argument against the proposal.
Capping pension fund managers' compensations would reduce the executives' incentives to maximize the value of the fund under their control, thereby reducing the overall return to the fund participants.
3. The division of a large office services company that makes high-end copiersrecently signed a five-year, $25 million contract for IT services from CGIGroup, a Canadian information technology company. If you were the managerof the division, how would you justify the long-term nature of your contractwith CGI Group?
Contracts requiring large specialized investments are expected to be longer than contracts requiring relatively smaller specialized investments. The reason is that transaction costs increase once the contract expires. By writing longer contracts, these costs can be avoided. Thus, large specialized investments increase the marginal benefit of writing longer contracts.
4. The Wall Street Journal reported that Juniper Networks, Inc.-a maker ofcompany network equipment-plans to offer its more than 1,000 employeesthe opportunity to reprice their stock options. Juniper's announcement comesat a time when its stock price is down 90 percent, leaving many employees'stock options worthless. How do you think Juniper's CEO justified repricing
the employees' stock options to the shareholders?
2. The first important point to make with shareholders is that restructuring the incentive plan is designed to maximize shareholder value. This is achieved by giving employees incentives to stay with the company longer, thereby reducing costly employee turnover and increasing the company's profitability. Also, by restructuring the incentive plan, employees will want to find ways to work more productively and make the company more profitable. The benefits to the shareholders and the employees will be a higher stock price.
5. EFI-a material handling company-pays each of its salespersons a basesalary plus a percentage of revenues generated. To reduce overhead, EFI hasswitched from giving each salesperson a company car to reimbursing them$0.35 for each business-related mile driven. Accounting records show that, onaverage, each salesperson drives 100 business-related miles per day, 240 daysper year. Can you think of an alternative way to restructure the compensationof EFI's sales force that could potentially enhance profits? Explain
3. The manager might pay a salesperson a base salary plus a percentage of the profits. This plan would penalize salespersons, to some extent, for excessive mileage.
6. Teletronics reported record profits of $100,000 last year and is on track toexceed those profits this year. Teletronics competes in a very competitive marketwhere many of the firms are merging in an attempt to gain competitiveadvantages. Currently, the company's top manager is compensated with a fixedsalary that does not include any performance bonuses. Explain why this managermight nonetheless have a strong incentive to maximize the firm's profits.
4. In the absence of an incentive contract, a manager may still choose to maximize profits in order to build a reputation in being a superb manager and increasing the potential of future management opportunities. Furthermore, the threat of a takeover by other investors and job loss also disciplines managers to maximize profits, even if they are paid a fixed salary.
7. HomeGrown is a small restaurant that specializes in serving local fruits, vegetables,and meats. The company has chosen to enter into a long-term relationshipwith Family Farms, a local farming operation. The two parties havedecided to enter into a long-term contract, where Family Farms will supplyproduce to HomeGrown at specified prices and volume each year. Beforesigning a contract, HomeGrown is trying to decide how long the contractshould be. It estimates that each year the contract covers saves the restaurant$1,000 in bargaining and opportunism costs. However, each year the contractcovers also requires more legal fees. HomeGrown estimates that the numberof hours required from lawyers, L, has a quadratic relationship with the numberof years on the contract, so that L !Y2, where Y is the number of yearsfor the contract. If HomeGrown's lawyers charge $100 per hour, how longshould the contract be?
5. The marginal benefit for each year of the contract is $1,000 as stated in the problem. The total cost of Y years is $100×L = $100×Y2. This means the marginal cost of Y years is $200×Y. Setting marginal benefit equal to marginal cost gives us Y = 5.