Creating Contracts to Avoid Moral Hazard Presentation
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:
Fixed fee: The new CEO will receive a fixed wage.
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.
- 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.
- 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.
- 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.
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