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Category > Economics Posted 03 May 2017 My Price 9.00

As chairman of the board of ASP Industries

*10. As chairman of the board of ASP Industries, you estimate that your annual profit is given by the table below. Profit (II) is conditional upon market demand and the effort of your new CEO. The probabilities of each demand condition occurring are also shown in the table.

 

MARKETDEMAND

LOWDEMAND

MEDIUMDEMAND

HIGHDEMAND

Market Probabilities

 

.30

 

.40

 

.30

Low Effort

II = $5 million

II = $10 million

II = $15 million

High Effort

II = $10 million

II = $15 million

II = $17 million

 

You must design a compensation package for the CEO that will maximize the firm’s expected profit. While the firm is risk neutral, the CEO is risk averse. The CEO’s utility function is

 

Utility  = W.5 when making low effort

Utility  = W.5  - 100 when making high effort

where W is the CEO’s income. (The - 100 is the “utility cost” to the CEO of making a high effort.) You know the CEO’s utility function, and both you and the CEO know all of the information in the preceding table. You do not know the level of the CEO’s effort at time of compensation or the exact state of demand. You do see the firm’s profit, however.

Of the three alternative compensation packages below, which do you as chairman of ASP Industries prefer? Why?

Package 1: Pay the CEO a flat salary of $575,000 per year

Package 2: Pay the CEO a fixed 6 percent of yearly firm profits

 

 

 

 

Package 3: Pay the CEO a flat salary of $500,000 per year and then 50 percent of any firm profits    above

$15 million

 

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Status NEW Posted 03 May 2017 08:05 PM My Price 9.00

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