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Chapter 13 PrinciplesPrinciples
ofof
CorporateCorporate
FinanceFinance
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
13- 2
Topics Covered
Incentives and CompensationMeasuring and Rewarding Performance:
Residual Income and EVABias in Accounting Measures of
Performance
13- 3
The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who has the power?
Answer: Managers
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 …
13- 5
Incentives
Reduced effortPerksEmpire buildingEntrenching investmentAvoiding risk
Agency Problems in Capital Budgeting
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.
13- 7
CEO Compensation (2005)T
hous
ands
of
Dol
lars
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.
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
equipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
13- 10
Residual Income & EVA
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
13.000,1
130ROI
Given COC = 10%
%3%10%13 NetROI
13- 11
Residual Income & EVA
Investment Capital ofCost - Earned Income
required income-Earned Income
Income Residual
EVA
Residual Income or EVA = Net Dollar return after deducting the cost of capital
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
13- 12
Residual Income & EVA
million 03$
)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.
13- 13
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.
13- 14
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.
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
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 $100 million. Given a 10% cost of capital, what is the EVA of the project and was it a good investment?
million 02$
)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.
13- 17
EVA of US firms - 2005
Econimic Value Added (EVA)
Capital Invested
Return on Capital
Cost of Capital
Microsoft 8,247 28,159 40.9 11.7 Johnson & Johnson 6,601 60,857 19.0 7.8 Wal-Mart Stores 5,199 109,393 10.8 5.8 Merck 3,765 32,400 18.4 7.6 Coca-Cola 3,637 18,353 25.3 5.9 Intel Corp 3,264 34,513 23.2 13.2 Dow Chemical 1,749 44,281 10.2 6.3 Boeing (67) 41,813 5.6 5.8 IBM (196) 71,196 10.5 10.8 Delta Airlines (1,413) 25,639 1.0 6.3 Pfizer (3,838) 209,293 5.8 7.6 Time Warner (5,153) 132,985 3.8 7.8 Lucent Technologies (6,279) 61,987 (0.7) 9.6
($ in millions)
13- 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
13- 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
13- 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
13- 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
13- 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
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
5 10 15 20 25
13- 24
Web Resources
www.sternstewart.com
http://www.emblemsvag.com/economic_profit.htm
Click to access web sitesClick to access web sites
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