Zorion Ltd, a private equity firm, is expanding into producing cost-effective small nuclear power plants. A scientist wi

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Zorion Ltd A Private Equity Firm Is Expanding Into Producing Cost Effective Small Nuclear Power Plants A Scientist Wi 1 (105.22 KiB) Viewed 17 times

Zorion Ltd, a private equity firm, is expanding into producing cost-effective small nuclear power plants. A scientist with considerable knowledge about the new technology runs the project as a CEO. Zorion takes a financial stake in the firm by funding the investment cost to maximize the financial return on the investment. You should assume in your answer that the market is risk-neutral and that the discount rate is zero. The following data is available on the new investment. The investment cost is £100m. The investment yields a financial success with probability p. The success value is £500m. With probability 1-p there is no financial payoff at all, although the project could still generate scientific value. The scientific value that the CEO cares about is B as long as Zorion invests. The CEO can forego the scientific value of B, in which case the success probability is pH = 0.8. The CEO can alternatively maximize the scientific value of the project, in which case the success probability is only PL = 0.1. The incentive package of the CEO is an incentive contract that pays an amount C to the CEO if the project is a financial success and nothing otherwise. The bonus is the only compensation paid to the CEO. Therefore, the value to the CEO is pHC if the CEO maximizes the financial value, and equal to PLC + B if the CEO maximizes the scientific value. The payoff to the shareholders is PH (£500m-C) if the CEO maximizes the financial value of the firm and p, (£500m - C) if the CEO maximizes the scientific value of the firm. (a) If B = 0, what is the value of the investment to Zorion's shareholders? (10 marks) (b) If B = 30m, should Zorion invest? What is the optimal bonus payment to the CEO in this case? (10 marks) (c) If B = 300m, should Zorion invest? What is the optimal bonus payment to the CEO in this case? (15 marks) (d) Discuss the problem of agency relationships between investors and managers critically. Also discuss whether society should offer an investment subsidy to Zorion in question (c), and if so, how big the offering should be. (15 marks)