Management Compensation Completing Lecture 20 Student Presentations Capital Investment Process Need for Good Information Incentives Stock Options Measuring and Rewarding Performance Economic Value Added ® Biases in Accounting Measures

WACC vs. Flow to Equity –If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were all-equity financed. The value of interest tax shields is picked up in the WACC formula.

WACC vs. Flow to Equity –The company's cash flows will probably not be forecasted to infinity. Financial managers usually forecast to a medium-term horizon -- ten years, say -- and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of post- horizon flows. Estimating the terminal value requires careful attention, because it often accounts for the majority of the value of the company.

WACC vs. Flow to Equity –Discounting at WACC values the assets and operations of the company. If the object is to value the company's equity, don't forget to subtract the value of the company's outstanding debt.

Using WACC in Practice Multiple sources of financing –Weighted average of each element Short term debt –Generally can be ignored Other current liabilities Costs of financing –Return on equity can be derived from market data –Cost of debt is set by the market given the specific rating of a firm’s debt –Preferred stock often has a preset dividend rate

WACC & Debt Ratios Example continued: Sangria and the Perpetual Crusher project at 20% D/V Step 1 – r at current debt of 40% Step 2 – D/V changes to 20% Note the debt-equity ratio is.2/.8 =.25 Step 3 – New WACC

Adjusted Present Value APV = Base Case NPV + PV Impact Base Case = All equity finance firm NPV PV Impact = all costs/benefits directly resulting from project

Example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Adjusted Present Value

Example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Project NPV = 150,000 Stock issue cost =-200,000 Adjusted NPV- 50,000 Don’t do the project Adjusted Present Value

Example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option. Adjusted Present Value

Example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option. Project NPV = - 20,000 Stock issue cost = 60,000 Adjusted NPV 40,000 Do the project Adjusted Present Value

Example – Rio Corporation APV

Adjusted Present Value Example – Rio Corporation APV - continued

The MFC corporation needs to raise $200 million for its mega project. The NPV of the project using all equity financing is $40 million. If the cost of raising funds for the project is $10 million, what is the APV of the project? A) $30 million. B) $40 million. C) $160 million. D) $210 million E) None of the above

Capital Investment Process Capital budgeting –Bottom-up Strategic planning –Top-down Project authorizations Investments missing from capital budget –Information technology (IT) –Research and development –Marketing –Training Post audits –What can be learned for next time

The Need for Good Information Consistent forecasts Reducing forecast bias –BMA Second Law “The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.” Eliminating conflicts of interest

Incentives Agency problems in capital budgeting –Reduced effort –Perks –Empire building –Entrenching investment –Avoiding risk Ways to reduce agency costs –Monitoring –Incentives

Monitoring Management of a Public Corporation Stockholders –Small stockholders –Large investors Individuals Pension fund Mutual fund Board of directors Auditors Lenders Rating agencies

Incentives Management compensation –Basic –Bonus –Benefits –Perks –Options CEO compensation relative to other employees –US –Internationally

Stock Options Estimated value in large US corporations –1992 $22 million/company –2000 $238 million/company –2002 $141 million/company Accounting choices for stock options –Consider the fair value of the option as an expense when the option is granted –Only deduct the excess of market price over exercise price (allowed until 2006) Options do not create taxable income for manager until they are exercised

Valuing a Stock Option Intrinsic value Time value Black-Scholes Option Pricing Model –Reasonable approximation for at the money options –Not as good for far in or out of the money options

Black-Scholes Option Pricing Model C= Price of a call option S= Current price of the asset X= Exercise price r= Risk free interest rate t= Time to expiration of the option σ = Volatility of the stock price N= Normal distribution function

Black-Scholes Option Pricing Model Values European options on stock Assumptions –No dividends –No taxes or transaction costs –One constant interest rate for borrowing or lending –Unlimited short selling allowed –Continuous markets –Distribution of terminal stock returns is lognormal Based on arbitrage portfolio containing stock and call options Required continuous rebalancing

Using the Black-Scholes Model Only variables needed –Underlying stock price –Exercise price –Time to expiration –Volatility of stock price –Risk-free interest rate

Example What is the value of call options on 100,000 shares of stock under the following: –Current stock price = $20 –Exercise price = $20 –Time to expiration = 5 years –Standard deviation of stock returns =.25 –Risk-free rate = 5%

Value of Each Option

Total Value of Option Grant 100,000 x 6.50 = $650,000 Ways to increase this value even more –Increase σ –Reprice the option if stock prices fall –Drive down the stock price to get a lower exercise price –Backdate the option to a time when stock prices were lower Not illegal as long as company expenses it properly

Measuring and Rewarding Performance Companies get the behavior they reward Companies reward performance they can measure How to you measure effective performance? –Accounting profits –Rates of return –Growth in earnings

Economic Value Added® Economic Value Added (EVA) –Earnings after deducting the cost of capital EVA = Residual income = Income earned – (cost of capital x investment) Advantages of EVA –Makes cost of capital visible to managers –Better than accounting income as an incentive Disadvantages of EVA –Biased data

A firm has an average investment of $1000 during the year. During the same time the firm has an after tax earnings of $150. If the cost of capital is 10%, calculate the economic value added (EVA) for the firm. A) $0 B) $50 C) $100 D) $120 E) None of the above

Biases in Accounting Measures New projects or start-up firms generate accounting losses the first few years Expenses are written off early in the investment process Proposal – measure economic profitability

Next Class Thursday, April 17 –Integrating Capital and Risk –Reading “The Insurative Model” by Prakash Shimpi, Risk Management August