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Chapter 12Principles of
Corporate FinanceTenth Edition
Agency Problems, Compensation, and
Performance Measurement
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
12-2
Topics Covered
Incentives and CompensationMeasuring and Rewarding Performance:
Residual Income and EVABias in Accounting Measures of
Performance
12-3
The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who has the power?
Answer: Managers
12-4
Incentive Bypass Problems
1. Too many projects for top management to analyze
2. Details are beyond the view of execs
3. Many decisions are not in the capital budget
4. Small decisions add up
5. Execs are also subject to human error
The correct decision
…
12-5
Incentives
Reduced effortPerksEmpire buildingEntrenching investmentAvoiding risk
Agency Problems in Capital Budgeting
12-6
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.
12-7
CEO Compensation (2008)Global CEO Compensation:
Levels and Mix Vary Considerably
Source: Towers Perrin’s proprietary data.
Median Total Direct Compensation for CEOs of Large Companies
$0
$2,000,000
$4,000,000
$6,000,000
$8,000,000
$10,000,000
Japan Brazil Belgium Germany Netherlands Spain France UnitedKingdom
Canada UnitedStates
Value in U.S.$
Long Term Incentive Plans
Target bonus
Base
12-8
CEO Compensation (2008)Global CEO Compensation:
Levels and Mix Vary ConsiderablyGrowth in CEO compensation in the U.S.
Source: Execucomp
Stock and option grants
Salary and bonus
12-9
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.
12-10
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
equipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
12-11
Residual Income & EVA
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
13.000,1
130ROI
Given COC = 10%
%3%10%13 NetROI
12-12
Residual Income & EVA
Investment Capital ofCost - Earned Income
required income-Earned Income
Income Residual
EVA
Residual Income or EVA = Net Dollar return after deducting the cost of capital
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
12-13
Residual Income & EVA
million 03$
)000,110(.130
Income Residual
EVA
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
Given COC = 10%
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
12-14
Economic Profit
Invested Capital)(
Profit Economic
rROI
EP
Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.
12-15
Economic Profit
million $30
1,000.10)-.13(
Invested Capital)(
rROIEP
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
Example at 10% COC continued.
12-16
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
12-17
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 $100 million. Given a 10% cost of capital, what is the EVA of the project and was it a good investment?
million 02$
)10010(.30
EVA
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.
12-18
Accounting Measurements
0
011 )(
price beginning
price in changereceipts cashreturn of Rate
P
PPC
Economic income = cash flow + change in present value
0
011 )(return of Rate
PV
PVPVC
12-19
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
12-20
Nodhead Book Income & ROI
1 2 3 4 5 6
Cash flow 100 200 250 298 298 297Book value at start of year, straight-line depreciation 1000 834 667 500 333 167Book value at end of year, straight-line depreciation 834 667 500 333 167 0Book depreciation 167 167 167 167 167 167Book income -67 33 83 131 131 130Book ROI -0.067 0.04 0.125 0.263 0.394 0.782Forecasted EVA (5-.1 *2) -167 -50 17 81 98 114
Year
12-21
Nodhead Store Forecasts
1 2 3 4 5 6
Cash flow 100 200 250 298 298 297PV, at start of year, 10 percent discount rate 1000 1000 900 740 516 270PV, at end of year, 10 percent discount rate 1000 900 740 516 270 0Economic depreciation 0 100 160 224 246 270Economic income 100 100 90 74 52 27Rate of return 0.1 0.1 0.1 0.1 0.1 0.1Forecasted EVA (5-.1*2) 0 0 0 0 0 0
Year
12-22
Nodhead Peer Book ROI1 2 3 4 5 6
Book Income for store
1 -67 33 83 131 131 1302 -67 33 83 131 1313 -67 33 83 1314 -67 33 835 -67 336 -67
Total book income -67 -33 50 181 312 443
Book value for store1 1000 834 667 500 333 1672 1000 834 667 500 3333 1000 834 667 5004 1000 834 6675 1000 8346 1000
Total book value 1000 1834 2501 3001 3334 3501
Book ROI for all stores -0.067 -0.018 0.02 0.06 0.094 0.126
EVA for all stores -166.73 -216.79 -200.19 -118.91 -20.96 92.66
Year
12-23
Web Resources
Click to access web sitesClick to access web sites
Internet connection requiredInternet connection required
www.sternstewart.com
http://www.emblemsvag.com/economic_profit.htm
