Chapter10_ Solutions

Chapter10_ Solutions - Suggested Solutions to Assigned...

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Suggested Solutions to Assigned Problems in Chapter 10: 1, 3, 14 1. a. The 10% bonus plan is designed to overcome the moral hazard problem which arises because the shareholders cannot observe management’s effort in operating the firm. If they received a straight salary, managers may be tempted to shirk. By giving managers a share in profits (which are informative about effort and payoff), their tendency to shirk is reduced. The lack of a cap could encourage the manager to undertake risky projects, since if these projects pay off the manager will receive high compensation. However, if they do not pay off, the lowest compensation the manager receives is zero (this assumes the manager does not have to pay the firm 10% of any losses). If shareholders are diversified, a reasonable level of firm risk may be in their best interests. However, if excessively risky projects are undertaken, the probability of financial distress, such as debt covenant violation or bankruptcy, is increased. This may not be in shareholders’ best interests since it is they that suffer any resulting losses. Since income tax expense may not be very informative about manager effort, Miracle-J Corp. must feel there is no need to deduct income tax in arriving at profits subject to bonus. A performance measure should be as informative as possible about manager effort. Evidently, Miracle-J Corp. believes that before-tax profit is such a measure. Note, however, that this will reduce management effort devoted to minimizing taxes. b.
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This note was uploaded on 12/14/2010 for the course ACC 706 taught by Professor Shadifarshad during the Winter '09 term at Ryerson.

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Chapter10_ Solutions - Suggested Solutions to Assigned...

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