1. Agency problems, compensation, and performance management12
Agency problems, compensation, and performance management
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 12-1 incentives and compensation
Principal Agent Problem
Shareholders = Owners
Managers = Employees
Managers have the power to manage investments
Managers have the power to manage day-to-day aspects of the firm. They also have more information than the shareholders.

3. 12-1 incentives and compensation
Incentive Bypass Problems
Too many projects for top management to analyze
Details are beyond the view of executives
Many decisions are not in capital budget
Small decisions add up
Executives are subject to human error
Information problems associated with capital budgeting are given. Timely and accurate information is essential to make good decisions that increase the value of a firm.

4. 12-1 incentives and compensation
Agency Problems in Capital Budgeting
Reduced effort
Perks
Empire building
Entrenching investment
These are agency problems associated with capital budgeting. These can be explained through examples. Managers may not put in enough effort. They may seek excessive perks. They may try to expand their department or engage in turf battles with other departments. They might promote projects that ensure their continued employment. They may not want to take risks at all. All these are inefficiencies that would reduce the value of a firm. The agency costs can be minimized through monitoring and appropriate incentive plans.

5. 12-1 incentives and compensation
Agency Problems and Risk Taking
Managers must take some risks along the way
Managers compensated with stock options have incentive to take risk
Gambling for redemption
Organizations hesitate to curtail successful risky activities
First, the managers who reach the top ranks of a large corporation must have taken some risks along the way. Managers who seek only the quiet life don’t get noticed and don’t get promoted rapidly.
Second, managers who are compensated with stock options have an incentive to take more risk. As we explain in Chapters 20 and 21, the value of an option increases when the risk of the firm increases.
Third, managers sometimes have nothing to lose by taking on risks. Suppose that a regional office suffers large, unexpected losses. The regional manager’s job is on the line, and in response he or she tries a risky strategy that offers a small probability of a big, quick payoff. If the strategy pays off, the losses are covered and the manager’s job may be saved. If it fails, nothing is lost, because the manager would have been fired anyway. This behavior is called gambling for redemption.
Fourth, organizations often hesitate to curtail risky activities that are delivering–at least temporarily–rich profits. The subprime crisis of provides sobering examples. Charles Prince, the pre-crisis CEO of Citigroup, was asked why that bank’s leveraged lending business was expanding so rapidly. Prince quipped, “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citi later took a $1.5 billion loss on this line of business.

6. 12-1 incentives and compensation
Monitoring
Board of Directors
Sarbanes-Oxley Act requires more independent directors
Auditors
Ensure consistency with generally accepted accounting principles (GAAP)
Lenders
Bank tracks company’s assets
Agency costs can be reduced by monitoring managers’ actions, but monitoring costs money and encounters diminishing returns. Monitoring is primarily done by the following entities:
The board of directors are elected to represent shareholder interests.
Auditors are independent accountants who audit the firms’ financial statements. Auditors can recommend changes and issue a qualified opinion, which suggests that managers are covering something up if their recommendations are not followed.
Lenders also monitor the assets of companies to which they have loaned large sums of capital in order to protect their own investments.

7. 12-1 incentives and compensation
Monitoring
Shareholders
Can take “Wall Street Walk”
Rival Companies
Can take over poorly run businesses
Shareholders can sell off their stock if they believe a company is being poorly managed. This is referred to as the “Wall Street Walk.” Rival companies can buy out a business which is not properly managing its assets.

8. 12-1 incentives and compensation
Management Compensation
How best to pay managers to
Reduce cost
Reduce need for monitoring
Maximize shareholder value
It is very difficult to monitor the actions of managers. Capital markets do monitor managers’ actions through the price mechanism. Generally, stock prices reflect the overall performance of a firm. Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.

9. Figure 12.1 u.s. ceo compensation (2010)
This is an interesting table that shows that CEO compensation in the U.S. is the highest in the world. A large part of CEO compensation in the U.S. is in the form stock options.

10. Figure 12.2 growth in ceo compensation
Another illustration of how CEO compensation has changed over time.

11. 12-1 incentives and compensation
Monitoring Pay for Performance
Attempt to ensure compensation is
Reasonable
Linked to performance
SEC and NYSE require independent compensation committees
Compensation tends to creep up
For U.S. public companies, compensation is the responsibility of the compensation committee of the board of directors. The Securities and Exchange Commission (SEC) and NYSE require that all directors on the compensation committee be independent.

12. 12-2 residual income and eva
Attempts to overcome errors in accounting measurements of performance
Emphasizes NPV over accounting standards
More long-term than short-term
More closely tracks shareholder value than accounting measurements
This frame provides two measures of performance that are superior to accounting measures. Several firms, including Coca-Cola, have used economic value added (EVA), developed by the consulting firm Stern-Stewart. These are the advantages of using EVA as a measure of performance. It is more closely related to shareholder value than other accounting measures of performance.

13. Table 12.1 statements of income, quayle city plant
This frame shows data that is needed to estimate EVA.

14. 12-2 residual income and eva
Quayle City Plant ($million)
Given COC = 10%
Net return on investment (net ROI) shows the residual return after taking into consideration the cost of capital.

15. 12-2 residual income and eva
Residual Income, or Economic Value Added (EVA)
EVA (developed and popularized by Stern–Stewart) measures the net dollar return after deducting the cost of capital. It reflects the increase in the value of the firm in dollar terms.
Economic value added = EBIT(1 – T) – (total investor supplied capital)(after-tax cost of capital)

16. 12-2 residual income and eva
Quayle City Plant ($million)
Given COC = 10%
EVA = residual income = 130 – (0.1)(1,000) = +30 million
Positive EVA means that the firm is adding to shareholder value.

17. 12-2 residual income and eva
Economic Profit
Capital invested times spread between return on investment (ROI) and cost of capital (COC)
The consulting firm McKinsey & Company uses economic profit (EP). This measure is similar to EVA. Economic profit (EP) gives the same result as the EVA.
EP = (ROI – r) × (capital invested)

18. 12-2 residual income and eva
Quayle City Plant ($Million)
COC = 10%
EP = (ROI – r)(capital invested) = (0.13 – 0.1)(1,000) = + 30 million
[Note: ROI = NI/TA = 130/1,000 = 0.13 = 13%]

19. 12-2 residual income and eva
Pros and Cons of EVA
Pros
Managers motivated to invest in projects that earn more than they cost
Makes cost of capital visible to managers
Leads to reduction in assets employed
Cons
Does not measure present value
Rewards quick paybacks
Ignores time value of money
These are some of the advantages and disadvantages of using EVA to reward performance.

20. 12-2 residual income and eva
EVA Example
Movie generates $30 million net income during 4-month run. Rentals/post-theater income forecasted nominal. Cost to produce was $100 million. Given 10% cost of capital, what is EVA of project and was it a good investment?
EVA is positive, but the project is a loser
This is a counterexample to show that EVA need not be applicable in all cases.

21. 12-3 biases in accounting measures of performance
Accounting Measurements
Economic income = cash flow + change in present value
The next two frames explain the difference between accounting measures of rate of return and economic rate of return.
Economic income = cash flow – economic depreciation
Economic depreciation = reduction in present value

22. 12-3 biases in accounting measures of performance
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
Shows the conceptual differences between economic income and accounting income.

23. Table 12.2 Nodhead book income and roi
Accounting measures are distorted because of the use of book values. Book depreciation is an arbitrary method used by accountants that has no bearing on the change in value of the assets.

24. Table 12.3 nodhead store forecasts
The rate of return is the economic rate of return and is constant each year. The book rate of return gives a distorted view of the firm’s performance. Book depreciation is an arbitrary method used by accountants that has no bearing on the change in value of the assets. These biases do not work out in the long run. High growth rate reduces the book rate of return.

25. Table 12.4 nodhead peer book roi
This slide compares EVA and book ROI for Nodhead.

26. Nodhead growth versus return
Rate of return (%)
Rate of growth (%)
Economic rate of return
Book rate of return 12 11 10 9 8 7
This frame is a graphical representation of the difference between book rate of return and economic rate of return.