Agency Problems Performance

8/10/2019 Agency Problems Performance

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1. Agency Relationships

Shareholders are the ultimate principals

They appoint the top management which is the

agent of the shareholders

The top management appoints the middle

management & employees, who are in turn the

agents of the top management

So top management is simultaneously agent wrt

shareholders & principal wrt rest of the firm

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1. Agency Relationships

Issues faced by top management:

1. Incentives: Offering the right incentives to

middle managers & employees to motivate

them to maximise firm value

2. Performance Measurement: Performance

measurement linked with measurement of

value added to the firm by managers &

employees

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2. Agency Problems in Capital Budgeting

A. Reduced EffortsB. Expensive Perks

C. Empire-Building

D. Entrenching Investment

E. Risk Avoidance

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A. Reduced Efforts: Managers may avoid the hardwork involved in identifying & planning +ve NPVinvestments (projects)

B. Expensive Perks: Managers may take expensive

perks not in cash but in kind, such as: clubmemberships, lavish office accommodation, stay atexpensive hotels in official tours

C. Empire-Building: Managers prefer to run largebusinesses than small ones. Increasing the size ofbusiness may not result in +ve NPV investments;managers are reluctant to disinvest even if the large

size is not profitable 5


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D. Entrenching Investment: Investmentsdesigned to require the skills of existing

managers are called entrenching investments.

The existing managers would favourthemselves by accepting such projects which

would require their special skills and would

reject those investments which would requirehiring managers with different skills / general

skills from outside6


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E. Risk Avoidance: If managers get fixed salaries theyhave no motivation to explore risky projects

because they do not get any share out of the

upside potential of risky projects. Moreover riskyprojects may also end up losing money, in which

the managers may lose their jobs. So from

viewpoint of such managers safe projects arebetter than risky ones.

Result: Firms will lose the upside potential of risky

projects. 7


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Note:

Generally entrenching investments & empire-building are symptoms of over-investment, i.e.

investment beyond the point where NPV = 0 Chances of over-investment are highest when firm

has plenty of cash but limited investment

opportunities: aka Free Cash Flow problem (Jensen) Since managers getting fixed salaries cannot avoid

the above agency problems the resulting loss in firmvalue is an agency cost.

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3. Reducing Agency Costs: Monitoring

Some of the agency costs may be reduced bymonitoring but not all

Common forms of monitoring:

Monitoring by Board of Directors (BoD): Formal &informal meetings of BoD with top management

Monitoring by External Auditors: Auditors Report

Monitoring by Lenders: Assets, Earnings & Cashflows

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3. Reducing Agency Costs: Monitoring

Free Rider Problem: In a large co. with many s/h, Nos/h monitors because the amount of time &expense is not justifiable for a single s/h. Each s/hwants to benefit from the monitoring done by other

s/hFree Rider Benefit Solution to Free-Rider Problem: Delegated

monitoringto be done by BoD, Auditors. But

delegated monitoring also results agency problemsMembers of BoD may be close to CEO, Auditorsmay be close to top management and may alsohave business relationships with the co.

Eg: Enron & its Auditors Arthur Andersen 10


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4. Measuring & Rewarding Performance

Top level managers of publicly traded cos:Compensation packages are dependent more

on the cos stock price performance than on

accounting measures of performance Lower Level Managers: Compensation

packages are dependent more on accounting

measures of performance than on the cosstock price performance

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Merits of Accounting Measures:

They are based on absolute performance & not

on performance with reference to investors

expectations

They are appropriate for measuring performance

of junior managers because they are responsible

for a single business unit: plant / division

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Demerits of Accounting Measures:

Accounting profits are partly within the control ofmanagement: eg. Improving short term profits by

sacrificing maintenance / staff training / marketing Accounting profits & rates of return may not reflect

true profits & returns

Growth in accounting profits does not ensure thatshareholder wealth will increase: Eg. Investing inprojects that offer +ve returns but less than cost ofcapital (-ve NPV)

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4A: Net Return on Investment

Net Return on Investment (NROI):

NROI = ROICost of Capital

ROI = Post-tax Operating Income / (Net BookValue of Assets)

Cost of Capital = WACC

If NROI > 0 then firm is adding to shareholdervalue

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4A: Eg. 1 (BM/p312)

The following data are available for a co:

The post-tax operating income is Rs. 130 m. Cost of capital is 10%

Calculate the NROI

Assets Amount (Rs. Million)

Net working capital 80

Fixed assets 1170Cumulative Depreciation 360

Other assets 110

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4A: Eg. 1 (BM/p312): Sol.

Step 1: Calculation of Investment

Step 2: Calculation of ROI

Step 3: Calculation of NROI

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4A: Eg. 1 (BM/p312): Sol.

Step 2: Calculating ROI:

ROI = Post-Tax Operating Income / Investment

= 130 / 1000 = 13%

Cost of capital = 10%

Step 3: Calculating NROI:

NROI = ROICost of capitalNROI = 1310 = 3%

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4B: EVA

Economic Value Added; aka Residual Income EVA = EBIT (1T)(Cost of Capital x Investment)

If EVA > 0 then the firm is adding shareholder value

This measure has been popularised & copyrightedby consulting firm Stern-Stewart & Co.

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4A: Eg. 2 (BM/p312-3)

The following data are available for a co:

The income statement is given in next slide

Assets Amount (Rs. Million)

Net working capital 80

Fixed assets 1170Less: Cumulative Depreciation 360

Net fixed assets 810

Other assets 110

Total assets 1000

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4A: Eg. 2 (BM/p312-3)

The cost of capital is 10%.

Calculate residual income or EVA.

Amount (Rs. Million)

Sales 550

Cost of goods sold 275

Selling, general & admin. expenses 75

Taxes @ 35% 70

Net income 130

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4A: Eg. 2 (BM/p313): Sol.

EVA = Residual income

= Income earnedIncome required

= Income earned(Cost of capital x

Investment)

= 130(0.10 x 1000) = Rs. 30 m.

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4C: NROI vs. EVA

Both EVA & NROI indicate the same thing However NROI ignores the scale of the co. in terms

of its investment in assets (capital employed). EVA

takes into account the capital employed andestimates the amount of shareholder wealth

created in terms of Rupees

NROI being in relative terms can be compared

across different firms but EVA is an absolute

measurehence cannot be compared

Cos. which are not Stern-Stewart clients use NROI23


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4D: Other Versions of Residual Income

McKinsey & Co. uses Economic Profit (EP):

EP = (ROICost of Capital) x Capital Invested

EVA or EP can be used for measuring & rewarding

performance inside the firm

Cos. which have higher ROI need not have higher

EVA because the amount of EVA is determined by

the amount of Capital invested and risk (which

affects the Cost of Capital)

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4E: Merits of EVA & Residual Income

Can be used as an incentive compensation system

Can be used as a substitute for explicit monitoring

by top managementplant & divisional managers

are rewarded only if they make careful investment

decisions

EVA makes cost of capital visible to managersthey

can improve EVA either by increasing earnings or by

reducing cost of capital; this can be done by

releasing funds tied up in underutilised assets &

excess working capital 25


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4F: Demerits of EVA & Residual Income

It requires that the managers be given the power to

influence those decisions which affect EVA: amount

of capital & their cost, components of revenues &

costshence not appropriate for junior managers

It cannot be judged whether a low EVA is a result of

bad management or due to factors beyond the

control of managersdown the hierarchy managershave lesser independence; hence this measure

cannot be used

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5 Biases in Accounting Measures of


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5. Biases in Accounting Measures of

Performance

Biases generally arise in cases like accounting for R&Dprogram in pharmaceuticals industry and accountingfor start up ventures

R&D programs in pharma. industry typically requireslarge scale investments & shows up any benefits onlyafter 10-12 years

Until such time the R&D program shows heavy

accounting losses because the GAAP requires thatoutlays for R&D be written off as a current expense

Start up ventures show heavy losses during the initialyears, though they may turn out to be highly profitable

+ve NPV investments in later years 27

5 Biases in Accounting Measures of


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5. Biases in Accounting Measures of

Performance

From an economic viewpoint the R&D outlayswhich are written off as expense leading toaccounting losses, are not expenses butinvestments

Similarly from an economic viewpoint, theaccounting losses shown by start up venturesduring the initial years are not losses but

investmentcash outlays which are necessary togenerate higher cash inflows in the later years

Hence these accounting losses lead to incorrect

measures of EVA or ROI 28


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5: Eg. 3:

A proposed investment in a super-market willrequire an initial investment of Rs. 1000000.

Projected financial data are:

The opportunity cost of capital is 10%

Calculate the NPV, IRR, Book ROI & EVA

Year 1 2 3 4 5 6

A Cash flow (Rs. 000) 100 200 250 298 298 298

B Book value at start of

year

1000 833 667 500 333 167

C Book value at end ofyear

833 667 500 333 167 0

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5: Eg. 3: Sol.

Step 1: Calculate Book ROI & EVA

Year 1 2 3 4 5 6

A Cash flow (Rs. 000) 100 200 250 298 298 298

B Book value at start of year 1000 833 667 500 333 167

C Book value at end of year 833 667 500 333 167 0

D Book depreciation (SL): B - C 167 167 167 167 167 167

E Book income: A-D -67 33 83 131 131 131F Book ROI: E/B -6.70% 4% 12.40% 26.20% 39.30% 78.70%

G EVA: E - (0.10 X B) -167 -50.3 16.3 81 97.7 114.3

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5: Eg. 3: Sol.

Step 2: Calculate NPV

Step 3: Calculate IRR

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5: Eg. 3: Observations

The book ROI is less than true return (IRR) in thefirst two years & higher afterward

This implies that accounting profitability measures

are too low when a project / business is young &are too high as it matures

The EVA isve in the initial two years & +ve

thereafter Theve EVA in years 1 & 2 is actually an investment

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6. Economic Profitability

The earlier distortions arise because book

profitability differs from true or economic

profitability

Economic profitability =

Economic income = Cash Flow + Change in PV

PV is the value of an asset / business / firm / project

Any decrease in PV is called economic depreciation

Any increase in PV isve economic depreciation

So change in PV is Increase/Decrease in value

PVBeginningIncomeEconomic

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6. Economic Profitability

Economic income

= Cash FlowEconomic depreciation

Economic depreciation = Decrease in PV from one

period to the next period

Economic Rate of Return =

C1is the cash flow at the end of period 1, PV0& PV1are the value of business at the end of periods 0 & 1

If there is economic depreciation then PV1< PV0

0

101 )(

PV

PVPVC

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6: Eg. 4

Calculate economic income, economic rate of

return & EVA for the forecasted cash flows of the

project given in Eg. 3

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6: Eg. 4: Sol.

Year 1 2 3 4 5 6

A Cash flow (Rs. 000) 100 200 250 298 298 298

B PV at start of year (10%) 1001 1001 901 741 517 271C PV at end of year (10%) 1001 901 741 517 271 0

D Economic depreciation: B-C 0 100 160 224 246 271

E Economic income: A-D 100 100 90 74 52 27

F Economic rate of return: (E/B)x100 10.00 10.00 10.00 10.00 10.00 10.00

G EVA = E - (Bx10%) 0 0 0 0 0 0

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6: Eg. 4: Observations

EVA is zero for every year

This is because every year the economic rate of

return = cost of capital

Hence in this case every year:

Economic income (Post-Tax EBIT) = cost of capital x

value at the start of the year

Hence EVA is zero every year

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6a: Accounting Biases

The biases in accounting measures of income &

profitability arise from NOT using economic

depreciation in calculating income

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