Agency Problems, Management Compensation

13- 5
McGraw Hill/Irwin
Incentive Issues
Monitoring - Reviewing the actions of managers and providing incentives to maximize shareholder value. Free Rider Problem - When owners rely on the efforts of others to monitor the company. Management Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.
13- 11
EVA Residual Income IncomeEarned- incomerequired
IncomeEarned- Cost of Capital Investment
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
13- 17
McGraw Hill/Irwin
Accounting Measurements
cash receipts changein price Rate of return beginningprice C1 ( P1 P0 ) P0
13- 18
Economic income = cash flow + change in present value
$500
$0
McGraw Hill/Irwin
Residual Income & EVA
Techniques for overcoming errors in accounting measurements of performance. Emphasizes NPV concepts in performance evaluation over accounting standards. Looks more to long term than short term decisions. More closely tracks shareholder value than accounting measurements.
McGraw Hill/Irwin
13- 6
CEO Compensation (2005)
$2,500
13- 7
$2,000
Thousands of Dollars
$1,500
$1,000
Long-term incentives & variable bonus Basic compensation, benefits, & perks
C1 ( PV1 PV0 ) Rate of return PV0
McGraw Hill/Irwin
Accounting Measurements
ECONOMIC INCOME Cash flow + change in PV = ACCOUNTING Cash flow +
13- 19
13- 16
EVA 30 (.10100) $20 million
Answer - While the EVA is positive, the movie industry highlights a major shortfall of EVA. It ignores the fact that no long term benefit accrues from a movie. Thus, the positive EVA is misleading. The project is a loser, despite its high quality subject matter.
13- 13
EP EconomicProfit ( ROI r ) CapitalInvested
McGraw Hill/Irwin
Economic Profit
Quayle City Subduction Plant ($mil)
Example at 10% COC continued.
Information Problems
1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest
McGraw Hill/Irwin
The Principal Agent Problem
Question: Who has the power?
13- 3
Shareholders = Owners
Answer: Managers
Managers = Employees
McGraw Hill/Irwin
McGraw Hill/Irwin
EVA of US firms - 2005
($ in millions)
Econimic Value Added (EVA) Microsoft Johnson & Johnson Wal-Mart Stores Merck Coca-Cola Intel Corp Dow Chemical Boeing IBM Delta Airlines Pfizer Time Warner Lucent Technologies 8,247 6,601 5,199 3,765 3,637 3,264 1,749 (67) (196) (1,413) (3,838) (5,153) (6,279) Capital Invested 28,159 60,857 109,393 32,400 18,353 34,513 44,281 41,813 71,196 25,639 209,293 132,985 61,987 Return on Capital 40.9 19.0 10.8 18.4 25.3 23.2 10.2 5.6 10.5 1.0 5.8 3.8 (0.7) Cost of Capital 11.7 7.8 5.8 7.6 5.9 13.2 6.3 5.8 10.8 6.3 7.6 7.8 9.6
13- 4
The correct information is …
McGraw Hill/Irwin
Incentives
Agency Problems in Capital Budgeting
Reduced effort Perks Empire building Entrenching investment Avoiding risk
13- 10
130 ROI .13 1,000
Given COC = 10%
NetROI 13% 10% 3%
McGraw Hill/Irwin
Residual Income & EVA
Residual Income or EVA = Net Dollar return after deducting the cost of capital
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
McGraw Hill/Irwin
Economic Profit
Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.
McGraw Hill/Irwin
13- 8
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Income Sales COGS Selling, G&A 550 275 75 200 Net W.C. Property, plant and equipment less depr. 1170 360 Assets 80
13- 9
taxes @ 35%
Net Income
70
$130
Net Invest..
Other assets
810
110
Total Assets
McGraw Hill/Irwin
$1,000
Residual Income & EVA
Quayle City Subduction Plant ($mil)
change in book value =
Cash flow economic depreciation
Cash flow -
accounting depreciation
RETURN
Economic income PV at start of year Accounting income BV at start of year
Principles of Corporate Finance
Ninth Edition
Chapter 13
Agency Problems, Management Compensation, and The Measurement of Performance
Slides by Matthew Will
McGraw Hill/Irwin
13- 2
Topics Covered
Incentives and Compensation Measuring and Rewarding PerformancBias in Accounting Measures of Performance
McGraw Hill/Irwin
Residual Income & EVA
Quayle City Subduction Plant ($mil)
13- 12
Given COC = 10%
EVA Residual Income 130 (.10 1,000) $30 million
13- 15
McGraw Hill/Irwin
EVA Lesson
Example – A movie producer generates $30 million in net income during the 4 month run of the movie “Revenge of the Finance Professors.” Movie rentals and post theater income is forecasted to be nominal. The cost to produce the movie was $100 million. Given a 10% cost of capital, what is the EVA of the project and was it a good investment?
13- 14
EP ( ROI r ) CapitalInvested (.13- .10) 1,000 $30 million
McGraw Hill/Irwin
Message of EVA
+ Managers are motivated to only invest in projects that earn more than they cost. + EVA makes cost of capital visible to managers. + Leads to a reduction in assets employed. - EVA does not measure present value - Rewards quick paybacks and ignores time value of money