Creating Contracts to Avoid Moral Hazard

Deliverable 4 - Creating Contracts to Avoid Moral Hazard 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.

Grading Rubric

F F C B A

0 1 2 3 4 Not

Submitted No Pass Competence Proficiency Mastery

Not Submitted

Introduction and/or conclusion did not summarize a well- justified recommendation.

Introduction and/or conclusion did summarize a well- justified recommendation.

Introduction and/or conclusion did summarize a well- justified recommendation, and included clear examples.

Introduction and/or conclusion did summarize a well- justified recommendation, used clear examples of each, and included a well-defined synopsis of the report goals.

Not Submitted

Explanation of profit sharing did not summarize the pros and cons.

Explanation of profit sharing summarized the pros and cons correctly.

Explanation of profit sharing summarized the pros and cons correctly, and used clear examples of each.

Explanation of profit sharing summarized the pros and cons, used clear examples of each, and included well-defined reasons for proposal recommendation.

Not Submitted

Explanation of stock options did not summarize the pros and cons.

Explanation of stock options summarized the pros and cons correctly.

Explanation of stock options summarized the pros and cons correctly, and used clear examples of each.

Explanation of stock options summarized the pros and cons, used clear examples of each, and included well-defined reasons for proposal recommendation.

Not Submitted

Explanation of fixed fees did not summarize the pros and cons.

Explanation of fixed fees summarized the pros and cons correctly.

Explanation of fixed fees summarized the pros and cons correctly, and used clear examples of each.

Explanation of fixed fees summarized the pros and cons, used clear examples of each, and included well-defined reasons for proposal recommendation.

Not Submitted

Explanation of bonuses did not summarize the pros and cons.

Explanation of bonuses summarized the pros and cons correctly.

Explanation of bonuses summarized the pros and cons correctly, and used clear examples of each.

Explanation of bonuses summarized the pros and cons, used clear examples of each, and included well-defined reasons for proposal recommendation.

Not Submitted

Explanation of combined stock option and bonus did not summarize the pros and cons.

Explanation of combined stock option and bonus summarized the pros and cons correctly.

Explanation of combined stock option and bonus summarized the pros and cons correctly, and used clear examples of each.

Explanation of combined stock option and bonus summarized the pros and cons, used clear examples of each, and included well-defined reasons for proposal recommendation.