Creating contracts to avoid moral hazard

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Competency

Demonstrate how economic theory contributes to strategic managerial decision-making.

Course Scenario

Oil Company X is a large oil refinery which has been expanding and taking on new investment projects. Recently, they have considered building a pipeline that stretches across the United States, from Canada to New Orleans.

The Board is in the process of hiring a new CEO for the firm. They are concerned about the problem of moral hazard and want to know how they can reduce or eliminate this via contract. They have tasked you, a team member in the Cost Department, with analyzing the following possible payment systems for the new CEO:

  1. Fixed fee: The new CEO will receive a fixed wage.
  2. Profit sharing: The new CEO receives 15% of the firm’s profit, with no wage. The current value of the firm’s profit, multiplied times 0.15, is equivalent to the fixed fee wage in option 1.
  3. Stock Options: The new CEO receives a base salary, with additional stock options tied to total profits. The base salary is 10% lower than the fixed fee from option 1, with the additional 10% given in stocks.
  4. Bonuses: The new CEO receives a base salary, with an additional stock bonus which is tied to total revenues. The base salary is 10% lower than the fixed fee from option 1, with the additional 10% given as a bonus tied to the total revenue from the prior year.
  5. Stock Options and Bonus: The new CEO receives a base salary, with additional stock options tied to total profits. The base salary is 10% lower than the fixed fee from option 1, with an additional 5% given in stocks and 5% given in the form of a bonus.

Instructions

You will create a presentation detailing the pros and cons of each potential payment system, including a final recommendation. Be sure to explain whether the firm or the CEO will bear all risk, or if they split the risk with each contract.

Record a presentation as if explaining this to the Board. There are many free screen recording software/Webware options available (such as Screencast-O-Matic) to use in presenting your PowerPoint. Make sure that both your voiced narration and the PowerPoint slides are captured during your screen recording.

After recording, paste a link to the recording on the last slide of the PowerPoint presentation. You will submit the PowerPoint in the Drop Box.

Format your PowerPoint to include a title page, introduction, body slides, conclusion, and references. Remember to cite your sources using correct APA format, and also use correct grammar, spelling, and formatting.