2 Topics Covered Incentives and Compensation Measuring and Rewarding Performance: Residual Income and EVABias in Accounting Measures of Performance222232
3 The Principal Agent Problem Question: Who has the power?Answer: ManagersShareholders = OwnersManagers = Employees
4 Incentive Bypass Problems Too many projects for top management to analyzeDetails are beyond the view of execsMany decisions are not in the capital budgetSmall decisions add upExecs are also subject to human errorThe correct decision …
5 Incentives Agency Problems in Capital Budgeting Reduced effort Perks Empire buildingEntrenching investmentAvoiding risk
6 Incentive IssuesMonitoring - 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.
7 Median Total Direct Compensation for CEOs of Large Companies CEO Compensation (2008)Global CEO Compensation: Levels and Mix Vary ConsiderablyMedian Total Direct Compensation for CEOs of Large Companies$0$2,000,000$4,000,000$6,000,000$8,000,000$10,000,000JapanBrazilBelgiumGermanyNetherlandsSpainFranceUnited KingdomCanadaUnited StatesValue in U.S.$Long Term Incentive PlansTarget bonusBaseSource: Towers Perrin’s proprietary data.
8 Growth in CEO compensation in the U.S. Global CEO Compensation: Levels and Mix Vary ConsiderablyGrowth in CEO compensation in the U.S.Stock and option grantsSalary and bonusSource: Execucomp
9 Residual Income & EVATechniques 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.
10 Residual Income & EVA Quayle City Subduction Plant ($mil) Income SalesCOGSSelling, G&A20035%Net Income $130AssetsNet W.CProperty, plant andequipment 1170less depr. 360Net InvestOther assets 110Total Assets $1,000
11 Residual Income & EVA Given COC = 10% Quayle City Subduction Plant ($mil)Given COC = 10%
12 Residual Income & EVAResidual Income or EVA = Net Dollar return after deducting the cost of capitalEVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
13 Residual Income & EVA Given COC = 10% Quayle City Subduction Plant ($mil)Given COC = 10%EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
14 Economic ProfitEconomic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.
15 Economic Profit Quayle City Subduction Plant ($mil) Example at 10% COC continued.
16 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
17 EVA LessonExample – 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.
18 Accounting Measurements Economic income = cash flow + change in present value
19 Accounting Measurements ECONOMIC ACCOUNTINGCash flow + Cash flow +change in PV = change in book value =Cash flow - Cash flow -economic depreciation accounting depreciationEconomic income Accounting incomePV at start of year BV at start of yearINCOMERETURN