If Hotel because it has the knowledge of whether or not they turned away a

If hotel because it has the knowledge of whether or

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the room been empty) or $150 (if the room could have been rented). If Hotel, because it has the knowledge of whether or not they turned away a paying guest, has the authority to set the
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Written Home Assignment 3 transfer price after each junket guest leaves, Hotel has incentives to lie about whether the room was rentable. Knowing that it will almost always be charged $150 for rooms, Gaming will tend not to invite gamblers unless they are expected to lose at least $150 per day. If Hotel has some empty rooms, it is best for Gaming to offer free lodging as long as the guest loses at least $25 to cover the cleaning cost. The preceding transfer pricing rule does not capture the complexities of most real-world situations. Suppose the hotel is at capacity 40 percent of the time. Then, one possible transfer price is $75 (0.40 x $150 + 0.60 x $25). However, this transfer price does not take into account the variation in occupancy rates between weekdays and weekends, holidays, conventions, seasons, and the quality of the entertainment playing at RRC on that day. It can become very time consuming to develop a menu of transfer prices that incorporates most realities and yet not be dependent on privately-held information by one division. Giving shares of the firm to divisional managers creates incentives for them to take actions to capture synergies across divisions. But additional company stock causes divisional managers to hold undiversifiable portfolios thereby increasing the amount of risk they bear. Moreover, small divisions, by definition, have little affect on firm-wide value and hence giving them stock creates little incentive to overcome the free-rider problem. Determining the optimum amount of stock to award divisional managers is tricky, but likely depends on the relative size of the division, the magnitude of the synergies, and the risk aversion of the managers. To avoid the under-diversification problem associated with awarding company stock to divisional managers, some companies link pay to firm-wide accounting- based earnings rather than stock. In the long run, stock and earnings are about equally risky. But over short time periods, accounting earnings impose less risk on managers than does common stock. Stock returns are sensitive to market-wide factors such as interest rates, tax policy, foreign currency fluctuations, and so forth. Firm-wide accounting earnings reduce risk, but still have free-rider problems. To reduce free-rider problems, firms like Fiat with numerous profit and investment centres combine divisions with significant synergies into groups headed by a group-level manager. By tying the group-level manager’s pay to group-level performance, this manager has incentive to capture the synergies among divisions in his or her group. By not paying any divisional manager a bonus unless the group makes its target or by linking divisional managers’ pay directly to group performance reduces the divisional managers’ myopic behaviour. However, adding group-level structures also has downsides. Another costly layer of management is created resulting in centralization of some decision making authority. This reduces the ability of divisions to respond quickly to unexpected events. While group-level structures better capture interactions among divisions within each group, they do
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  • Fall '18
  • RRC

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