Chapter 12 Principles of Corporate Finance Eighth Edition Agency Problems, Management Compensation, and The Measurement of Performance Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  The Capital Investment Process  Decision Makers Need Good Information  Incentives  Residual Income and EVA  Bias in Accounting Measures of Performance  Measuring Economic Profitability

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Investment Decision Project Creation “Bottom Up” Strategic Planning “Top Down” Capital Investments

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Investment Process  Capital budget  Project authorization  R&D  Marketing  Post-audits

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Off Budget Expenditures  Information Technology  Research and Development  Marketing  Training and Development

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Brealey, Myers & Allen’s Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin CEO Compensation ( )

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Economic Profit © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission. Quayle City Subduction Plant ($mil) Example at 10% COC continued.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin EVA of US firms ($ in millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Accounting Measurements Economic income = cash flow + change in present value

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Nodhead Book Income & ROI

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Elements of a Desirable Monitoring System  Long Run View:  Can distinguish between desirable and undesirable decisions  Reflects what is happening to the stockholders’ wealth  Takes into account scarce capital allocations  Takes into account the opportunity cost of capital How does EVA and ROI do with respect to these?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Nodhead Store Forecasts Economic Profitability

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Elements of a Desirable Monitoring System  Long Run View:  Can distinguish between desirable and undesirable decisions  Reflects what is happening to the stockholders’ wealth  Takes into account scarce capital allocations  Takes into account the opportunity cost of capital How does Economic Profitability and Rate of Return do on these dimensions?

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