Chapter 13 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Agency Problems, Management Compensation,

and The Measurement of Performance

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

13- 2

Topics Covered

Incentives and CompensationMeasuring and Rewarding Performance:

Residual Income and EVABias in Accounting Measures of

Performance

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The Principal Agent Problem

Shareholders = Owners

Managers = Employees

Question: Who has the power?

Answer: Managers

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Information Problems

1. Consistent Forecasts

2. Reducing Forecast Bias

3. Getting Senior Management Needed Information

4. Eliminating Conflicts of Interest

The correct information

is …

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Incentives

Reduced effortPerksEmpire buildingEntrenching investmentAvoiding risk

Agency Problems in Capital Budgeting

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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.

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CEO Compensation (2005)T

hous

ands

of

Dol

lars

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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.

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Residual Income & EVA

Income

Sales 550

COGS 275

Selling, G&A 75

200

taxes @ 35% 70

Net Income $130

Assets

Net W.C. 80

Property, plant and

equipment 1170

less depr. 360

Net Invest.. 810

Other assets 110

Total Assets $1,000

Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)

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Residual Income & EVA

Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)

13.000,1

130ROI

Given COC = 10%

%3%10%13 NetROI

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Residual Income & EVA

Investment Capital ofCost - Earned Income

required income-Earned Income

Income Residual

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.

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Residual Income & EVA

million 03$

)000,110(.130

Income Residual

EVA

Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)

Given COC = 10%

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

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Economic Profit

Invested Capital)(

Profit Economic

rROI

EP

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

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Economic Profit

million $30

1,000.10)-.13(

Invested Capital)(

rROIEP

Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)

Example at 10% COC continued.

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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

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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?

million 02$

)10010(.30

EVA

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.

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EVA of US firms - 2005

Econimic Value Added (EVA)

Capital Invested

Return on Capital

Cost of Capital

Microsoft 8,247 28,159 40.9 11.7 Johnson & Johnson 6,601 60,857 19.0 7.8 Wal-Mart Stores 5,199 109,393 10.8 5.8 Merck 3,765 32,400 18.4 7.6 Coca-Cola 3,637 18,353 25.3 5.9 Intel Corp 3,264 34,513 23.2 13.2 Dow Chemical 1,749 44,281 10.2 6.3 Boeing (67) 41,813 5.6 5.8 IBM (196) 71,196 10.5 10.8 Delta Airlines (1,413) 25,639 1.0 6.3 Pfizer (3,838) 209,293 5.8 7.6 Time Warner (5,153) 132,985 3.8 7.8 Lucent Technologies (6,279) 61,987 (0.7) 9.6

($ in millions)

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Accounting Measurements

0

011 )(

price beginning

price in changereceipts cashreturn of Rate

P

PPC

Economic income = cash flow + change in present value

0

011 )(return of Rate

PV

PVPVC

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Accounting Measurements

ECONOMIC ACCOUNTING

Cash flow + Cash flow +

change in PV = change in book value =

Cash flow - Cash flow -

economic depreciation accounting depreciation

Economic income Accounting income

PV at start of year BV at start of year

INCOME

RETURN

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Nodhead Book Income & ROI

1 2 3 4 5 6

Cash flow 100 200 250 298 298 297Book value at start of year, straight-line depreciation 1000 834 667 500 333 167Book value at end of year, straight-line depreciation 834 667 500 333 167 0Book depreciation 167 167 167 167 167 167Book income -67 33 83 131 131 130Book ROI -0.067 0.04 0.125 0.263 0.394 0.782Forecasted EVA (5-.1 *2) -167 -50 17 81 98 114

Year

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Nodhead Store Forecasts

1 2 3 4 5 6

Cash flow 100 200 250 298 298 297PV, at start of year, 10 percent discount rate 1000 1000 900 740 516 270PV, at end of year, 10 percent discount rate 1000 900 740 516 270 0Economic depreciation 0 100 160 224 246 270Economic income 100 100 90 74 52 27Rate of return 0.1 0.1 0.1 0.1 0.1 0.1Forecasted EVA (5-.1*2) 0 0 0 0 0 0

Year

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Nodhead Peer Book ROI1 2 3 4 5 6

Book Income for store

1 -67 33 83 131 131 1302 -67 33 83 131 1313 -67 33 83 1314 -67 33 835 -67 336 -67

Total book income -67 -33 50 181 312 443

Book value for store1 1000 834 667 500 333 1672 1000 834 667 500 3333 1000 834 667 5004 1000 834 6675 1000 8346 1000

Total book value 1000 1834 2501 3001 3334 3501

Book ROI for all stores -0.067 -0.018 0.02 0.06 0.094 0.126

EVA for all stores -166.73 -216.79 -200.19 -118.91 -20.96 92.66

Year

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Nodhead Growth v. Return

Rate of Return (%)

Rate of Growth (%)

Economic rate of return

Book rate of return

12

11

10

9

8

7

5 10 15 20 25

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Web Resources

www.sternstewart.com

http://www.emblemsvag.com/economic_profit.htm

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