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Finance FHS Tutorial 8 Answers
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Finance FHS Tutorial 8 Answers: Corporate Governance
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Finance Tutorial 7Question 1
a. First suppose that, due to a weak economy, there is no demand for Putt’s labour outside Chalk; so
Putt’s reservation wage is w = 0.
Using the simple P/A model developed in class, find a shareholder-value maximizing compensation
package for Putt; determine Putt’s optimal level of effort under this plan; and determine the payoff to
the shareholders of Chalk
Correct.
, b. Now suppose that Chalk has some good luck. The demand for chalk soars because a preliminary
medical research report suggests that eating chalk cures a common viral disease. This news doubles
Chalk’s value. So now vH = 10 and vL = 2. Assuming that, except for this change, all the other
parameters in part (1a) remain unchanged, find a shareholder-value maximizing compensation
package for Putt; determine Putt’s optimal level of effort under this plan; and determine the payoff to
the shareholders of Chalk. Explain briefly how Chalk’s good luck affects the compensation offered to
Putt and Putt’s welfare.
Correct.
Why optimal result is different: on the (vL/vH, pL/pH) Chart we expect it to be the same point. However,
the boundaries for OP, LE, L, H changes (since they are dependent on specific parameter values as well)
Own thoughts: from lowered effort (LE) to overpayment (OP). In first best case with observable effort,
would induce high effort. Initially not worth it to induce high effort, after change in outcomes, now it is
worth it to induce high effort, but CEO earns more than (w+c), overpaid due to unobservable effort for
incentive compatibility.
c. Now return to part (1a) assumptions but suppose that the macroeconomic climate has improved.
Because of this good economic news, Chalk is now able to secure alternative employment (which does
not require working past 2PM) with other firms. Alternative employment pays w = 1. Assuming that,
except for this change, all the other parameters in part (1a) remain unchanged, find a shareholder-
value maximizing compensation package for Putt; determine Putt’s optimal level of effort under this
plan; and determine the payoff to the shareholders of Chalk. Explain briefly how this fortuitous
improvement in the economic climate affects the compensation offered to Putt and Putt’s welfare.
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