1. 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

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

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

4. 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 …

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

6. 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.

7. 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.

8. 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

9. 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.

10. Residual Income & EVA Quayle City Subduction Plant ($mil) Income
Sales
COGS
Selling, G&A
200
35%
Net Income $130
Assets
Net W.C
Property, plant and
equipment 1170
less depr. 360
Net Invest
Other assets 110
Total Assets $1,000

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

12. 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.

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 Profit
Economic 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 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.

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

19. 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

20. Nodhead Book Income & ROI

21. Nodhead Store Forecasts

22. Nodhead Peer Book ROI

23. Web Resources Click to access web sites Internet connection required