Agency Problems, Compensation, and Performance Measurement Principles of Corporate Finance Tenth Edition Chapter 12 Agency Problems, Compensation, and Performance Measurement Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered Incentives and Compensation Measuring and Rewarding Performance: Residual Income and EVA Bias in Accounting Measures of Performance 2 2 2 2 3 2

The Principal Agent Problem Question: Who has the power? Answer: Managers Shareholders = Owners Managers = Employees

Incentive Bypass Problems Too many projects for top management to analyze Details are beyond the view of execs Many decisions are not in the capital budget Small decisions add up Execs are also subject to human error The correct decision …

Incentives Agency Problems in Capital Budgeting Reduced effort Perks Empire building Entrenching investment Avoiding risk

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.

Median Total Direct Compensation for CEOs of Large Companies CEO Compensation (2008) Global CEO Compensation: Levels and Mix Vary Considerably Median Total Direct Compensation for CEOs of Large Companies $0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000 Japan Brazil Belgium Germany Netherlands Spain France United Kingdom Canada United States Value in U.S.$ Long Term Incentive Plans Target bonus Base Source: Towers Perrin’s proprietary data.

Growth in CEO compensation in the U.S. Global CEO Compensation: Levels and Mix Vary Considerably Growth in CEO compensation in the U.S. Stock and option grants Salary and bonus Source: Execucomp

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.

Residual Income & EVA Quayle City Subduction Plant ($mil) 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

Residual Income & EVA Given COC = 10% Quayle City Subduction Plant ($mil) Given COC = 10%

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.

Residual Income & EVA Given COC = 10% Quayle City Subduction Plant ($mil) Given COC = 10% EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

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

Economic Profit Quayle City Subduction Plant ($mil) Example at 10% COC continued.

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

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? 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.

Accounting Measurements Economic income = cash flow + change in present value

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

Nodhead Book Income & ROI

Nodhead Store Forecasts

Nodhead Peer Book ROI

Web Resources Click to access web sites Internet connection required www.sternstewart.com http://www.emblemsvag.com/economic_profit.htm