Deliverable 4 - Creating Contracts to Avoid Moral Hazard C.docx

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.
sharing summarized
the pros and cons
correctly, and used
clear examples of
each.
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
for proposal
recommendation.
Not
Submitted
Explanation of fixed
fees did not
summarize the pros
and cons.
fees summarized
the pros and cons
correctly.
fees summarized the
pros and cons

correctly, and used
clear examples of
each.
fees summarized the
pros and cons, used
clear examples of
each, and included
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
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.
Deliverable 4 - Creating Contracts to Avoid Moral Hazard
Module 4 Introduction
In this module, you will have the opportunity to master the
following
competency:
• Demonstrate how economic theory contributes to strategic
managerial
decision-making.
Further, the content in this module will help you achieve the
following learning
objectives:
• Assess the degree of risk and expected profit from a financial
investment.
• Evaluate how attitudes toward risk affect choice under
uncertainty, and
actions that decision makers can take to reduce their risk.
• Evaluate the ways adverse selection and moral hazards prevent

desirable transactions, and methods that can reduce adverse
selection
and moral hazards.
• Create contracts that reduce or eliminate moral hazard.
• Assessing Risk and Expected
With every investment decision, there is a degree of risk, as
well as a certain
amount of profit to be gained. The degree of risk can be
quantified by
calculating the probability that an event will or will not occur.
We can then
use these probabilities to calculate the expected profit from an
investment.
With any event that could occur, there is a certain probability
between zero
and one that is associated with its occurrence. If there were 0%
chance the
event would occur, the probability would be zero. If we are
100% certain this
event will occur, the probability will be one. Similarly, a 50%
chance of
occurrence would have a probability of 0.5, a 30% chance of 0.3
and so forth.

Whenever we look at a series of events, we will see that their
probabilities will
add up to 1.0, but they must be mutually exclusiveand
exhaustive. Imagine
that we are flipping a coin. There are two possible outcomes:
heads or tails.
These events are mutually exclusive in that you can obtain a
head or a tail,
but you cannot obtain both on the same flip. They are also
exhaustive, since
there is no third possibility. Hence, each possible event will
have a probability
of 0.5 and will add up to 1.
Now, imagine rolling a six-sided dice. There are six possible
outcomes, with
an equal probability of rolling a one, two, three, etc. Hence, the
probability of
each outcome is one out of six, or 1/6. These events are
mutually exclusive
and exhaustive, so the probabilities will add up to 1.
Once we know the probabilities of our outcomes, as well as the
potential profit

to be earned, we can calculate the expected value as follows,
where n is the
number of outcomes, Prn is the probability of the nth outcome,
and Vn is the
value of the nth outcome:
EV = Pr1V1 + Pr2V2 + ... + PrnVn
The calculation for expected value weights each are valued (V1,
V2, etc.) by
its respective probability of occurrence (Pr1, Pr2, etc.), and
these weights are
then summed together.
To see this in action, let us say Jeff is offered the chance to roll
a dice. If he
rolls an odd number, he receives the amount of the roll in
dollars ($1, $3, or
$5). If he rolls an even number, he must pay the amount of the
roll in dollars
($2, $4, or $6). Right away, we can see that this probably is not
a good bet,
but let us calculate the expected value to see for sure. First, we
weight the
probabilities of each roll with their respective values.

EV = Pr1V1 + Pr2V2 + Pr3V3 + Pr4V4 + Pr5V5 + Pr6V6
Since each roll has a probability of 1/6:
EV = (1/6) ($1) + (1/6) (-$2) + (1/6) ($3) + (1/6) (-$4) + (1/6)
($5) + (1/6) (-$6)
Note that a loss has a negative value and that a gain has a
positive value.
This simplifies to:
EV = $1/6 - $2/6 + $3/6 - $4/6 + $5/6 - $1 = - 3/6 = - $0.50
Playing this game a repeated number of times would yield an
expected value
of a 50-cent loss. While expected value is obviously a good
number to know if
he plays the game repeatedly, it does not tell us how risky an
investment is,
were he to play the game just once. This is where the variance
comes into
play.
Let us say Jeff is then offered the chance to play a similar
game, but this time
the value of the roll results in that amount being won when 1-5
are rolled ($1,

$2, $3, $4, or $5). However, Jeff will lose $18 by rolling a six.
Calculate the
expected value on your own to see that the second game has the
same
expected value as the first.
Clearly, however, these two games do not carry the same risk.
To find the
risk, use the formula for variance below:
Var(σ2) = Pr1(V1−EV)2 + Pr2(V2−EV)2 + ... + Prn(Vn−EV)2
To find the variance, take the difference between each
outcome's value and
the expected value of playing the game. This figure is squared
then weighted
by that outcome's respective probability. All figures are then
summed to yield
the variance of the game. A higher variance indicates higher
risk, while lower
variance indicates lower risk. In the business world, standard
deviation (σ) is
often reported rather than variance. Simply take the square root
of σ2 to
obtain σ.

Attitudes Toward Risk
As you may have noticed, different people have different
attitudes toward risk.
They can be risk-aversive, risk-neutral, or risk-preferring.
In order to determine which category an investor falls into, look
at their
willingness to place a fair bet. A fair bet is an investment in
which the
expected value is zero. An example of this would be flipping a
coin, where you
pay a dollar if you get heads and you gain a dollar if you get
tails. A risk-
neutral person looks only at the expected value, so they’re
indifferent to taking
the bet. Most people, however, are risk-aversive. Despite this
being a fair bet,
they will be unwilling to take the bet because they do not like
risk. Conversely,
some people love risk, as evidenced by the multitude of
gambling institutions.
These investors would be considered risk-preferring and would
always take
the fair bet.
In an ideal world, managers would be risk-neutral and would be

expected to
maximize expected profit. However, managers come to the table
with their
own attitudes toward risk, which can sometimes cause them to
make risk-
averse or risk-preferring decisions, even if shareholders prefer
risk-neutral
decisions. Since managers are essentially gambling with other
people’s
money, they may not be inclined to always act in the
shareholder’s best
interest. The manager may be concerned about losing their job
if a large loss
occurs and may be afraid to take a fair bet. The manager may
also be looking
at short-run profits that will benefit themselves, while setting
the company up
for financial troubles in the long run.
There are several things managers can do to decrease risks.
First, they can
obtain as much information as possible about potential
investments. They can

also decide to purchase insurance. Since risk-aversive
individuals are willing
to pay a risk premium to avoid risk, it makes sense that they
would also be
willing to pay for insurance that effectively transfers the risk
from the individual
to the insurance company.
One of the most important ways for an investor to reduce or
eliminate risk is
through diversification. Diversification involves placing
investments into
different firms, different industries, and even different
countries, with the
intention of negating some of the diversifiable risk. There are
two main types
of risk:
1. Systematic
2. Unsystematic risk
Systematic Risk: This is essentially the risk involved with the
economic
system. Whenever there is a major economic event such as a
recession or an

economic boom, there will be widespread changes to the
economy as a
whole. It is very difficult to reduce systematic risk by
diversifying our portfolio.
In fact, other names for this type of risk are undiversifiable
risk, or market
risk.
Unsystematic Risk: This type of risk is also called diversifiable
risk, or
specific risk. This is risk that applies to a limited segment of
investments. It
could apply to risk in one firm, such as when laborers go on
strike. It could
also apply to one industry, such as the oil industry if a very
cheap source of
alternative energy were developed. Unsystematic risk could just
impact one
country. However, even if an economic upset occurs in one
specific country,
you could see an additional risk with your other assets. We live
in a globalized
world where major economic events in one country tend to
traverse to

another. Regardless, some economic events will impact the
economy in one
country much more than the rest of the world. Hence, it is still
advisable to
diversify your portfolio by investing not only in different firms
and different
industries, but also in different countries.
In addition to diversifying across several firms, industries, and
countries, your
portfolio should also be spread amongst several types of
investment
instruments. Some should be kept as cash, and some as stocks or
bonds, and
some as mutual funds. You may also consider investments such
as rental real
estate or land.
Rather than only choosing safe investments, or only choosing
riskier
investments, you should consider a combination of both
conservative and
aggressive investments. Conservative investments have lower
risk and lower

expected returns, while aggressive investments have higher risk
and higher
returns. Diversifying between the two ensures that some of your
investment is
yielding a high return, with the remainder safeguarded. While
diversification is
important, investment managers also recommend a portfolio
with a higher
percentage of aggressive investments at a younger age, when
you can afford
to start over; moving more of your wealth to conservative
investments as you
move closer to retirement.
Reducing Moral Hazard Through
Moral hazards occur when one party bears all of the risk of an
operation.
After a financial transaction takes place, the other party may
change their
behavior to the detriment of the other party. Because one party
bears all of the
risk, this increases the incentive for the other party to act
negligently.
Typically, the moral hazard occurs because an agent, such as an
employee,
does not always act in the best interest of the principal, such as

an employer.
The principal cannot closely monitor his agent. This is called
the principal-
agent problem and is a common issue faced by business
managers.
One way to reduce moral hazards is through carefully designed
contracts.
There are two types of contracts that are commonly utilized to
reduce or
eliminate moral hazard: fixed-fee contracts and contingent
contracts.
Fixed-fee Contracts
Let us say that Sue owns a hair salon and hires Jeff to cut hair
at her salon. If
Jeff is paid by the hour, he has little incentive to perform his
best work. Sue
will bear the costs as her business’s reputation suffers along
with her profits.
In this case, Sue bears all of the risk of Jeff’s hairstyling skills,
while Jeff
himself bears no risk. In order to prevent this, Sue can charge
Jeff $250 a

month for a chair at the salon, allowing him to keep all residual
profits. This is
called a fixed-fee contract. Jeff’s take home pay increases if he
uses more of
his skills while on the job. There is also a transfer of risk in this
situation, as
Jeff now bears all of the risk while Sue bears none.
Contingent Contracts
Another type of contract used to reduce moral hazard is a
contingent
contract, in which payment from the principal to the agent is
contingent on
some condition being met. There are several types of contingent
contracts.
State-Contingent Contracts
In a state-contingent contract, one party’s payoff is contingent
on only the state of
nature. For example, let us say Sue’s hair salon is located near a
ski resort in a town
with a small population. Both Sue and Jeff know that there is a
huge increase in
demand during the winter months, with a sharp drop-off in
demand in the summer

months. Jeff would like to continue working in the summer, but
may not be able to afford
the steep rental price. Sue would rather have Jeff work during
the summer at a lower
rental cost then have an empty chair in her salon during those
months. The two can
work out a contract that is contingent upon demand, where Jeff
pays $250 a month
during the winter and $100 during the summer. However, a
state-contingent contract
depends on both parties agreeing on the state of nature.
Profit-Sharing Contracts
With a profit-sharing contract, the agent receives some of the
overall profit. Rather than
rent a chair, Jeff would receive some of the overall profit that
Sue’s business earns. This
will encourage Jeff to work hard, but only if the percentage of
profit received is great
enough to offset the additional work he must do in order to
obtain it. This contract may
not work if there is a new stylist, Mark, who does not receive a
share of the profit. He
does not have any incentive to work harder, so Jeff must work
extra hard in order to
make up for Mark’s laziness. Jeff may not have the incentive to
invest his time and
resources if the profit-sharing percentage is too small.
Bonuses and Options
Sue could also offer Jeff a bonus if profits exceed a certain
amount, or she could offer
him stock options in the company. As the company profits

increase, so will the value of
Jeff’s stock, encouraging him to work harder.
Piece Rates and Commissions
The final type of contingent contract is a piece-rate contract.
Here, the agent receives a
payment for each unit of output the agent produces. For every
haircut that Jeff gives, he
receives a certain rate. Sue could also pay him a commission, or
percentage, of each
sale. This would be better for a company where speed is
essential in an operation.
However, the hair salon will greatly depend upon the quality of
the service as well, and
Sue may not want to stake her business’s reputation. This also
does not allow for
uncertainty for fluctuations in demand. Jeff will still receive
significantly less during the
summer months when the tourism industry dies down.

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