1. Chapter 13 Principles PrinciplesofCorporateFinance Ninth Edition Agency Problems, Management Compensation, and The Measurement of Performance Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. 13- 2 Topics Covered  Incentives and Compensation  Measuring and Rewarding Performance: Residual Income and EVA  Bias in Accounting Measures of Performance

3. 13- 3 The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

4. 13- 4 Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

5. 13- 5 Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

6. 13- 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. 13- 7 CEO Compensation (2005) Thousands of Dollars

8. 13- 8 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.

9. 13- 9 Residual Income & EVA Income Sales 550 COGS 275 Selling, G&A 75 200 taxes @ 35% 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)

10. 13- 10 Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

11. 13- 11 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.

12. 13- 12 Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10% © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

13. 13- 13 Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

14. 13- 14 Economic Profit Quayle City Subduction Plant ($mil) Example at 10% COC continued.

15. 13- 15 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

16. 13- 16 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.

17. 13- 17 EVA of US firms - 2005 ($ in millions)

18. 13- 18 Accounting Measurements Economic income = cash flow + change in present value

19. 13- 19 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

20. 13- 20 Nodhead Book Income & ROI

21. 13- 21 Nodhead Store Forecasts

22. 13- 22 Nodhead Peer Book ROI

23. 13- 23 Nodhead Growth v. Return Rate of Return (%) Rate of Growth (%) Economic rate of return Book rate of return 12 11 10 9 8 7 510152025

24. 13- 24 Web Resources www.sternstewart.com http://www.emblemsvag.com/economic_profit.htm Click to access web sites Internet connection required