Leonardo, a senior executive at the Las Vegas Home Bank, either offers only low-risk prime mortgages or a combination of prime and riskier subprime mortgages. If he provides only prime mortgages, the bank's profit is $480 million with certainty. If he sell both prime and subprime mortgages, the bank earns $2,400 million with a 25% probability or - $960 million with a 75% probability, because subprime loans carry a high risk of default. Before, Leonardo received 1% of the bank's profit if it was positive and nothing (but got to keep his job) if it was negative. Under his new contract, Leonardo receives a salary of $3.6 million a year and 0.25% of the bank's profit. If the bank suffers a loss, Leonardo is fired, so that he loses his salary and receives no bonus. Assume Leonardo is risk neutral. Show that shareholders' expected earnings are higher with the new compensation scheme than with the original one. With the original compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are Smillion. (Enter your response as a whole number and include a minus sign if necessary.) With the new compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are Smillion. (Enter your response as a whole number and include a minus sign if necessary.)
Leonardo, a senior executive at the Las Vegas Home Bank, either offers only low-risk prime mortgages or a combination of prime and riskier subprime mortgages. If he provides only prime mortgages, the bank's profit is $480 million with certainty. If he sell both prime and subprime mortgages, the bank earns $2,400 million with a 25% probability or - $960 million with a 75% probability, because subprime loans carry a high risk of default. Before, Leonardo received 1% of the bank's profit if it was positive and nothing (but got to keep his job) if it was negative. Under his new contract, Leonardo receives a salary of $3.6 million a year and 0.25% of the bank's profit. If the bank suffers a loss, Leonardo is fired, so that he loses his salary and receives no bonus. Assume Leonardo is risk neutral. Show that shareholders' expected earnings are higher with the new compensation scheme than with the original one. With the original compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are Smillion. (Enter your response as a whole number and include a minus sign if necessary.) With the new compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are Smillion. (Enter your response as a whole number and include a minus sign if necessary.)
Chapter18: Accounting Periods And Methods
Section: Chapter Questions
Problem 68P
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Transcribed Image Text:Leonardo, a senior executive at the Las Vegas Home Bank, either offers only low-risk prime mortgages or a combination of prime and riskier subprime mortgages. If he provides only prime mortgages, the bank's profit is $480
million with certainty. If he sell both prime and subprime mortgages, the bank earns $2,400 million with a 25% probability or - S960 million with a 75% probability, because subprime loans carry a high risk of default.
Before, Leonardo received 1% of the bank's profit if it was positive and nothing (but got to keep his job) if it was negative. Under his new contract, Leonardo receives a salary of $3.6 million a year and 0.25% of the bank's profit. If
the bank suffers a loss, Leonardo is fired, so that he loses his salary and receives no bonus.
Assume Leonardo is risk neutral.
Show that shareholders' expected earnings are higher with the new compensation scheme than with the original one.
With the original compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are S million. (Enter your response as a whole number and include a minus sign if necessary.)
With the new compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are $ million. (Enter your response as a whole number and include a minus sign if necessary.)
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