 Making Sure Managers Maximize NPV Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 12 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Topics Covered  The capital investment process  Decision Makers and Information  Incentives  Residual Income and EVA  Accounting Performance Measures  Economic Profit

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Investment Decision Project Creation “Bottom Up” Strategic Planning “Top Down” Capital Investments

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Off Budget Expenditures  Information Technology  Research and Development  Marketing  Training and Development

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Growth and Returns Rate of return, % Rate of growth, % Economic rate of return Book rate of return

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Brealey & Myers Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.  Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Residual Income & EVA Income Sales550 COGS275 Selling, G&A % 70 Net Income$130 Assets Net W.C. 80 Property, plant and equipment1170 less depr.360 Net Invest..810 Other assets110 Total Assets$1,000 Quayle City Subduction Plant ($mil)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 12%

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Economic Profit © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission. Quayle City Subduction Plant ($mil) Example at 12% COC continued.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill EVA of US firms $ in millions)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Accounting Measurements

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Accounting Measurements Economic income = cash flow + change in present value

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Accounting Measurements ECONOMICACCOUNTING Cash flow +Cash flow + change in PV =change in book value =Cash flow - economic depreciationaccounting depreciation Economic incomeAccounting income PV at start of yearBV at start of year INCOME RETURN

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Nodhead Store Forecastes

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Nodhead Book Income & ROI