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Advanced Get research paper samples and course-specific study resources under   homework for you course hero writing service – Manage rial Accounting Practice Final Exam

Advanced Get research paper samples and course-specific study resources under   homework for you course hero writing service – Manage rial Accounting Practice Final Exam (1 hr and 50 mins)
Prof. Ajay Maindiratta
Q1. Consider the following agency setting:
Risk neutral firm owner
Risk averse salesperson (with utility function U = (C)1/2, where C is money)
The salesperson provides one of two possible effort levels (Work or Shirk) which together with nature’s play (“intrinsic demand” : Strong,
Moderate, or Poor) determines revenue as per the following table:
Nature’s play: probability
Strong demand (SD): 0.2 Mod. Demand (MD): 0.5 Poor demand (PD): 0.3
Work (W) $700 $700 $100
Shirk (S) $700 $100 $100
The Salesperson has other opportunities such that to join the firm and work he wants at least 15 in Expected Utility (EU). However, he is also
effort averse, such that having joined he will work only if it provides him with at least 10 more in EU than if he shirks.
Assume that the owner gets to play the Shirk lottery even if the salesperson does not join.
Required: [Throughout your answer, use the compensation notation C( . , . ) as we used in class.]
A: When effort is observable…
1. What is the best compensation contract?
C(W, $700) = C(W, $100) = (15)2 = $225; C(S, $700) = C(S, $100) = 0
2. Is it worth employing the agent?
The owner’s net expected payoff from the Shirk lottery (which he gets without the salesperson)
= 0.2×700 + 0.8×100 = $220.
His net expected payoff from the Work lottery = 0.7×700 + 0.3×100 − 225 = $295
Yes. It is worth employing the salesperson.
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B: When effort is unobservable…
1. What is the owner’s design problem (i.e., objective function and constraints)? Compensation is only a function of revenue:
Minimize: Expected Cost (EC) = 0.7× C($700) + 0.3× C($100)
Subject to:
RU condition: 0.7×[C($700)]1/2 + 0.3×[C($100)]1/2 ≥ 15
IC condition: {0.7×[C($700)]1/2 + 0.3×[C($100)]1/2}−{0.2×[C($700)]1/2 + 0.8×[C($100)]1/2} ≥ 10
Nonnegativity conditions: C($700) ≥ 0 and C($100) ≥ 0
2. What is the optimal compensation contract? (The optimal is at the intersection of the two constraints and you can proceed by setting them as
equalities and solving.)
Given that the RU and IC constraints are satisfied as equalities in this case, we solve
0.7×[C($700)]1/2 + 0.3×[C($100)]1/2 = 15
0.5×[C($700)]1/2 − 0.5×[C($100)]1/2 = 10
⇒ [C($700)]1/2 = 21 & [C($100)]1/2 = 1 ⇒ C($700) = $441 & C($100) = $1 ⇒ EC = $309
3. What is the agency cost due to effort being unobservable? = (309 − 225) = $84
4. Is it now worth employing the salesperson?
The principal’s net expected payoff from the Work lottery now = 0.7×700 + 0.3×100 − 309 = $211
This is less than the $220 payoff from the shirk lottery (which is available without the agent).
⇒ It is now not worth employing the salesperson.
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Q2. Continuing with the effort unobservable case:
A market research firm offers to survey the market and report on its intrinsic demand.
The survey result comes only after the salesperson has already chosen his effort, but in time to be used to determine his compensation.
The survey is imperfect in that it can only signal if market demand is Poor (SP) or Not Poor (SNP). However, it is powerful enough such that
Prob (SNP | SD) = Prob (SNP | MD) = Prob (SP | PD) = 1
1. What are now the observables on which compensation can be made to depend?
The observables now are the revenue and the market survey report.
2. What are thus the possible contingent compensation levels? (Use the notation we used in class.)
Contingent compensation is thus fourfold:
C($700, SP); C($700, SNP); C($100, SP); and C($100, SNP)
3. What then are the Work and Shirk lotteries that the agent faces? Proceed as suggested below.
3 a. First compute the joint probabilities of each combination of “nature’s” moves
The joint probabilities of nature’s plays (intrinsic demand & survey result) are:
prob (SP & SD) = prob (SP | SD) × prob (SD) = 0 × 0.2 = 0
prob (SNP & SD) = prob (SNP | SD) × prob (SD) = 1 × 0.2 = 0.2
prob (SP & MD) = prob (SP | MD) × prob (MD) = 0 × 0.5 = 0
prob (SNP & MD) = prob (SNP | MD) × prob (MD) = 1 × 0.5 = 0.5
prob (SP & PD) = prob (SP | PD) × prob (PD) = 1 × 0.3 = 0.3
prob (SNP & PD) = prob (SNP | PD) × prob (PD) = 0 × 0.3 = 0
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3 b. Then fill up the salesperson’s payoff table below to determine the lottery choices he faces. (Decide yourself on the number of columns
you need. In the cells in the first blank row list nature’s moves and the probability of each combination; in the cells in the second and third
blank rows list the compensation the agent gets in each situation using the notation from 2 above.)
Effort choice
Scenario: probability
(SNP & SD) : 0.2 (SNP & MD) : 0.5 (SP & PD) : 0.3
Work C($700, SNP) ≡ C7SNP C($700, SNP) ≡ C7SNP C($100, SP) ≡ C1SP
Shirk C($700, SNP) ≡ C7SNP C($100, SNP) ≡ C1SNP C($100, SP) ≡ C1SP
3 c. Finally present the choices from the table in tree form below (there may be extra branches below)
The salesperson chooses between the following 2 lotteries:
Work (W) lottery Shirk (S) lottery
0.7 C7SNP 0.2 C7SNP

0.5 C1SNP

0.3 C1SP 0.3 C1SP
4. What is the owner’s design problem now (i.e., objective function and constraints)?
Minimize Expected Cost (EC) = 0.7× C7SNP + 0.3× C1SP
Subject to :
RU condition: 0.7×(C7SNP)
1/2 + 0.3×(C1SP)
1/2 ≥ 15
IC condition: {0.7×(C7SNP)
1/2 +0.3×(C1SP)
1/2} − {0.2×(C7SNP)
1/2 +0.5×(C1SNP)
1/2 +0.3×(C1SP)
1/2} ≥ 10
Nonnegativity conditions: C7SNP ≥ 0, C1SNP ≥ 0, and C1SP ≥ 0
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5. Using the concepts you have learned, order the optimal compensation levels from highest to lowest. Provide the reasoning behind your
ordering.
First, note that C7SP can be set to anything at all since ($700, SP) will never be observed.
Next, we can say that: C7SNP > C1SP ≥ C1SNP = 0 . The reasoning is:
• When ($100, SNP) is observed ⇒ the agent definitely shirked ⇒ C1SNP = $0
• When ($100, SP) is observed, it is indeed possible that the agent worked ⇒ C1SP ≥ C1SNP
• Working has more impact on the likelihood of ($700, SNP) than on the likelihood of ($100, SP)
• marginal reasoning then ⇒ the agent should be rewarded more when former occurs
⇒ C7SNP > C1SP
* i.e., {Prob($700, SNP ; W) − Prob($700, SNP ; S)} > {Prob($100, SP ; W) − Prob($100, SP ; S)}
6. Solve for the optimal compensation levels (given that the constraints are indeed tight at the optimum).
Since as observed above, C1SNP = $0, the two equations to be solved are:
0.7×(C7SNP)
1/2 + 0.3×(C1SP)
1/2 = 15 and 0.5×(C7SNP)
1/2
= 10 ⇒ C7SNP = $400 and C1SP = $11.11
7. Is it now worth employing the salesperson?
⇒ Expected Cost (EC) = 0.7× C7SNP + 0.3× C1SP = $283.33
⇒ principal’s net expected payoff from the Work lottery = 0.7×700 + 0.3×100 − 283.33 = $236.67
This is more than the $220 payoff from the shirk lottery ⇒ It is worth employing the salesperson.
8. What is the most the owner should pay for the market survey?
$16.67 (=236.67 − 220), recalling that without the survey the agent will not be employed and the shirk
lottery will be played for an expected payoff of $220.
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Q3. Give brief, to-the point, answers below (no essays).
Considering the basic agency model that we have studied in class (and you have addressed in Questions 3 and 4 above):
1. Comment upon the relationship between risk sharing and the provision of incentives when the agent’s effort cannot be observed, versus in
the situation when effort can be observed?
There is a trade-off between risk sharing and the provision of incentives when effort is unobservable
that is not faced when effort is observable.
2. What is the consequence of effort unobservability?
The trade off results in a dead-weight loss (in comparison to the effort observable setting)
3. What is this consequence commonly termed? agency cost.
4. For additional metrics to be valuable for contracting, what property must they have (multiple choice):
a. be controllable by the agent
b. be incrementally informative about the effort
c. be both controllable by the agent and incrementally informative about the effort
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Q4. Omega Glove Company is considering switching its product line from leather gloves to Thinsulate gloves.
With some additional cutting equipment, costing $30,000, Thinsulate gloves can be made on the same old equipment as the leather gloves.
The old equipment has current tax basis (book value) of 50,000, remaining life of three years, and expected salvage value of $10,000 thereafter.
For tax reporting, it will be fully depreciated, straight line over its remaining three-year life.
The cutting equipment also has a life of three years, at the end of which it is expected to have a salvage value of $5,000. For tax reporting, it
can be fully depreciated, straight line over its three-year life.
The company has enough leather supplies to make only 2 years worth of leather gloves. [These supplies have a book value of $100,000 but can
be sold immediately for $120,000.] New leather supplies in the third year will cost $55,000.
Thinsulate supplies will cost $60,000 annually.
If Thinsulate gloves are made, revenues and other operating expenses (all cash) will respectively increase by $20,000 and $10,000 annually.
Additional working capital of $10,000 will also be required at the outset. This will be released at the end of three years.
Part 1. Required. Should Omega make the change from leather to Thinsulate gloves? Use the two tables that follow (there may be extra rows).
Frame the decision as: A: Switch to Thinsulate gloves and sell old leather supplies; B: Continue making leather gloves.
Its tax rate is 20%. Its after-tax cost-of-capital is 4% per year. Tax returns are filed and tax is paid at the end of the year.
Incremental taxable income from switching to Thinsulate gloves.
Time points 0 1 2 3
Incremental revenues
Revenue 20,000 20,000 20,000
Gain on sale of leather (120,000 − 100,000) 20,000
Gain on salvage of cutting equipment 5,000
Incremental expenses
Supplies expense (Thinsulate/Leather) (10,000) (10,000) (5,000)
Operating expenses (10,000) (10,000) (10,000)
Depreciation on cutting equipment (10,000) (10,000) (10,000)
[Total 0] Incremental taxable income 10,000 (10,000) 0
Incremental tax cash flow at 20% (2,000) 2,000 0
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Incremental cash flows from switching to Thinsulate gloves.
Time points 0 1 2 3
Incremental receipts
Revenue 20,000 20,000 20,000
Leather supplies sale proceeds 120,000
Cutting equipment salvage 5,000
Working capital 10,000
Incremental expenditures
Cutting equipment purchase (30,000)
Working capital (10,000)
Spending on Supplies (Thinsulate/Leather) (60,000) (60,000) (5,000)
Operating expenses (10,000) (10,000) (10,000)
[Total 0] Incremental before-tax cash flow 80,000 (50,000) (50,000) 20,000
Incremental tax from taxable income table (2,000) 2,000 0
Incremental after-tax cash flow 80,000 (52,000) (48,000) 20,000
PV factor at 4% after-tax 1 0.9615 0.9246 0.8890
NPV of proposal $3,401 ⇒ Switch to Thinsulate gloves.
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Q5. The Kappa Manufacturing Co. has an inventory of 500 units of product left over from last year’s model, which it expects to be able to
sell to its regular customers for $21 each. Sales commission on these sales would be $1 each. There would be no other costs.
Another customer, Charlie Co., would like to buy 500 units with the functionality of Kappa’s new model.
So for this customer, Kappa could
• Produce new model units from scratch on its assembly line. Kappa has ample spare capacity on the new model assembly line to do this.
• Or refurbish and upgrade the units left over from last year’s model (to have the same functionality as the new model).
Producing the units from scratch will need Direct Material of $10 each and Direct Labor* of $8 each.
The new units will also need to be tested. However, Kappa’s regular testing machine is expected to be fully occupied with other jobs.
Thus, to test this new production, Kappa would have to give up renting out (for a week) a second testing machine** that it owns.
Running this second testing machine requires Utilities of $1,000 weekly, but, when rented out, utilities are paid for by the renter.
Refurbishing the old units will need Direct Labor* of $4 each, but no assembly line capacity or testing.
_______________________________
* Variable manufacturing overhead is incurred in any case at the rate of $0.25 per $ of Direct Labor.
** The accountant reports that the weekly profit from the rental of the second testing machine is:
Rental Revenue $900
Insurance on machine# (10)
Depreciation on machine (30)
Allocated manufacturing and corporate overhead (20)
Weekly Profit $840
# Insurance has to be paid whether Kappa uses the testing machine itself or rents it out.
Required: If Kappa accepts the customer’s order, what should it do?
Frame the choice as “A: Produce units for Charlie from scratch” vs. “B: Refurbish old units for Charlie”.
If you are making any assumption in doing the analysis, state it explicitly. And before you present your analysis, identify the resources already
at hand that are differential given the framing.
Use the next blank page to present your work.
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Assumption: __________________________________________________________________________________
The resources-at-hand that are differential given the framing are: _________________________________________
______________________________________________________________________________________________
The differential analysis is:
A: Produce…. B: Refurbish….

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