}H— 304 Part Three Best Practices in Capital Budgeting all directors on the compensation committee be independent, that is, not managers or employees and not linked to the company by some other relationship—for example, a lucrative consulting contract—that would undercut their independence. The committee typically hires outside con: sultants to advise on compensation trends and on compensation levels in peer companies, ‘You can see how compensation tends to creep up. The problem is that boards don't want to approve below-average compensation. But if every firm wants to be above-average, then the average will ratchet up.” ‘Once the compensation package is approved by the committee, itis described in an annual Compensation Discussion and Analysis (CD&A), which is sent to shareholders along with. director nominations and the company’s 10-K filing. (The 10-K is the annual report to the SEC.) ‘On January 2011, the SEC gave shareholders a nonbinding yes-or-no vote on the CD&A at least ‘once every three years, Other countries that have given shareholders nonbinding votes on com- pensation include Australia, Sweden, and the UK. Shareholders in the Netherlands have a bind- ing vote. The occasional no vote on management compensation is a disagreeable wake-up call for managers and directors. Hewlett-Packard stockholders voted no in 2011, for example. Yet these safeguards dont satisfy everyone. Just as Dr. Suess predicted, we now have pay- watcher-watchers, such as the consulting company ISS. ISS reviews CD&As for thousands. cof companies, looking especially at pay-for-performance standards. 18's clients are mostly institutional investors, who seek advice on how to vote. (A mutual fund or pension fund may own shares in hundreds of companies. The company may decide to outsource the analysis of CD&AS to a specialist company like ISS.) EZ] Measuring and Rewarding Performance: Residual Income and EVA ‘Almost all top executives of firms with publicly traded shares have compensation packages that, depend in part on their firms’ stock price performance. But their compensation also includes a bonus that depends on increases in earnings or on other accounting measures of performance. For lower-level managers, compensation packages usually depend more on accounting mea: sures and less on stock returns. ‘Accounting measures of performance have two advantages: 1. They are based on absolute performance, rather than on performance relative to inves tors’ expectations. 2. They make it possible to measure the performance of junior managers whose responsi bility extends to only a single division or plant. ‘Tying compensation to accounting profits also creates some obvious problems. For example, managers whose pay or promotion depends on short-term profits may cut back on training, advertising, or R&D. This is not a recipe for adding value because these outlays are investments that should pay off in later years. Nevertheless the outlays are treated as current expenses and deducted from current income. Thus an ambitious manager is tempted to cut back, thereby increasing current income, leaving longer-run problems to his or her successor. In addition, accounting earnings and rates of return can be severely biased measures of true profitability. We ignore this problem for now, but return to it in the next section, Finally, growth in earnings does not necessarily mean that sharcholders are better off, Any investment with a positive rate of return (1% or 2% will do) will eventually increase earnings. "ra Lemmon and Naven foun th os es et poy evel or ahove the ean ofthe per gro, and some Fen ga sac her Forerample Coes Col and TBM consistent a for lees inthe tp quar of thee pers Se. M. Bigjal, M1. Leto, fan I, Nace, "asthe Use of Per Groups Contebued to Higher Pay and Less ilicent Compensation?” Jounal of Financ co. ics 90 (November 208), pp. 152-168Chapter 12 Problems, Compensation, and Performance Sales Net working capita? Property plant, ane Cost of goods sol* ‘equipment investment Selling, general, and Less cumulative administrative expenses epreciation| Net investment “Taos at 35% Other assets ‘Net income Total assets D TABLE 12.1 Simplified statements of income and assets for the Quayle City confabulator plant (figures in millions). Stncudesdoprocaton expense curent assets less current labs. Therefore, if managers are told to maximize growth in earnings, they will dutifully invest in projects offering 1% or 2% rates of return—projects that destroy value. But shareholders do not want growth in earnings for its own sake, and they are not content with 1% or 2% returns. ‘They want positive-NPV investments, and only positive-NPV investments. ‘They want the company to invest only if the expected rate of return exceeds the cost of capital Look at Table 12.1, which contains a simplified income statement and balance sheet for your company’s Quayle City confabulator plant. There are two methods for judging whether the plant's returns are higher than the cost of capital. Net Return on Investment Book return on investment (RON) is just the ratio of after-tax ‘operating income to the net (depreciated) book value of assets." In Chapter 5 we rejected book ROI as a capital investment criterion, and in faet few companies now use it for that purpose. However, managers frequently assess the performance of a division or a plant by comparing its ROI with the cost of capital. Suppose you need to assess the performance of the Quayle City plant. As you can see from lable 12.1, the corporation has $1,000 million invested in the plant, which is generating earnings of $130 million. Therefore the plant is earning an ROL of 130/1,000 = .13, or 139%." Ifthe cost of capital is (say) 10%, then the plant's activities are adding to shareholder value. The net return. is 13 — 10 = 3%. Ifthe cost of capital is (say) 20%, then shareholders would have been better off investing $1 billion somewhere else. In this case the net return is negative, at 13 ~ 20 = ~79% Residual Income or Economic Value Added (EVA®)"® ‘The second method calculates a net dollar return to shareholders. It asks, What are earnings after deducting a charge for the cost of capital? ‘Notice hat investment incldes the nt working capa current assets mous current abit) required © operate the plan. The lomstment shen tals aed met nets or the net itl vest nthe plat, We ty “ROL but you illo hea etorn on cap HOG. "Ket on aes" (ROA) sometimes refers return on assets defined o Include net working api asin Table 12.1, but neimes to geturn on total asset, where current acts ae ince but caren Iblis are not subtracted Is prudent to check reviewing reported ROIs, ROCs, of ROAS None hat caning arecalaltd afr tat bt wh no dations rintrst paid. The plat seated asiit eral guy anes This standard practie (ee Chapter 6)- It hes to separate invest and acing decons The a aang of debt nang, spore by the plant are picked up nat nthe plans earningy res Hows but the dicount te. The cost fetal isthe ae ta sgt average ost of pital or WACC: WAC was rl into in Chapter 9 and willbe further explained in Chapters 17nd 9 VA ie he term used bythe consiting fim Sern-Stwart, which has done mich to populrine an plement tis meesire of residual income, With Ster-Stewars pemison, we omit the copyright symbol n wha follows 305 +—