Agency Problems, Management Compensation

,
and The Measurement of Performance

McGraw Hill/Irwin

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

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

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

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

How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.Reviewing the actions of managers and providing incentives to maximize shareholder value.When owners rely on the efforts of others to monitor the company. .  Management Compensation .  Free Rider Problem . Incentive Issues  Monitoring .

benefits.000 Basic compensation. & perks $500 $0 .500 $2.000 Thousands of Dollars $1. CEO Compensation (2005) $2.500 Long-term incentives & variable bonus $1.

 Emphasizes NPV concepts in performance evaluation over accounting standards.  Looks more to long term than short term decisions. . Residual Income & EVA  Techniques for overcoming errors in accounting measurements of performance.  More closely tracks shareholder value than accounting measurements.

G&A 75 equipment 1170 200 less depr.000 . 810 Net Income $130 Other assets 110 Total Assets $1. Residual Income & EVA Quayle City Subduction Plant ($mil) Income Assets Sales 550 Net W. 80 COGS 275 Property. plant and Selling. 360 taxes @ 35% 70 Net Invest.C..

Residual Income & EVA Quayle City Subduction Plant ($mil) 130 ROI = = .13 1.000 Given COC = 10% NetROI = 13% − 10% = 3% .

income required = Income Earned .[Cost of Capital × Investment] . Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital EVA = Residual Income = Income Earned .

10 × 1.Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10% EVA = Residual Income = 130 − (.000) = +$30 million .

Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. EP = Economic Profit = ( ROI − r ) × Capital Invested .

Economic Profit Quayle City Subduction Plant ($mil) Example at 10% COC continued.10) × 1. EP = ( ROI − r ) × Capital Invested = (..13 .000 = $30 million .

.EVA does not measure present value . Message of EVA + Managers are motivated to only invest in projects that earn more than they cost.Rewards quick paybacks and ignores time value of money . + Leads to a reduction in assets employed. + EVA makes cost of capital visible to managers.

Given a 10% cost of capital. The cost to produce the movie was $100 million. what is the EVA of the project and was it a good investment? EVA = 30 − (. Thus.10 ×100) = $20 million Answer . despite its high quality subject matter. . It ignores the fact that no long term benefit accrues from a movie. the movie industry highlights a major shortfall of EVA. The project is a loser. 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.While the EVA is positive. the positive EVA is misleading.

247 28.279) 61.353 25.7) 9.5 10.8 Delta Airlines (1.2005 ($ in millions) Econimic Value Added Capital Return on Cost of (EVA) Invested Capital Capital Microsoft 8.293 5.513 23.9 Intel Corp 3.393 10.765 32.281 10.985 3.813 5.7 Johnson & Johnson 6.639 1.8 IBM (196) 71.857 19.2 13.8 7.6 Time Warner (5.196 10.0 6.6 5.199 109.3 Pfizer (3.987 (0.400 18.8 Wal-Mart Stores 5.601 60.838) 209.637 18.153) 132.8 7.264 34.9 11.413) 25.8 Lucent Technologies (6.2 6.3 5. EVA of US firms .159 40.3 Boeing (67) 41.2 Dow Chemical 1.6 .4 7.0 7.6 Coca-Cola 3.749 44.8 5.8 Merck 3.

Accounting Measurements cash receipts + change in price Rate of return = beginning price C1 + ( P1 − P0 ) = P0 Economic income = cash flow + change in present value C1 + ( PV1 − PV0 ) Rate of return = PV0 .

Accounting Measurements ECONOMIC ACCOUNTING INCOME Cash flow + Cash flow + change in PV = change in book value = Cash flow . Cash flow - economic depreciation accounting depreciation RETURN Economic income Accounting income PV at start of year BV at start of year .

Nodhead Book Income & ROI Year 1 2 3 4 5 6 Cash flow 100 200 250 298 298 297 Book value at start of year. straight-line depreciation 834 667 500 333 167 0 Book depreciation 167 167 167 167 167 167 Book income -67 33 83 131 131 130 Book ROI -0.04 0.067 0.394 0. straight-line depreciation 1000 834 667 500 333 167 Book value at end of year.1 *2) -167 -50 17 81 98 114 .125 0.263 0.782 Forecasted EVA (5-.

Nodhead Store Forecasts Year 1 2 3 4 5 6 Cash flow 100 200 250 298 298 297 PV.1 Forecasted EVA (5-. 10 percent discount rate 1000 900 740 516 270 0 Economic depreciation 0 100 160 224 246 270 Economic income 100 100 90 74 52 27 Rate of return 0.1 0.1 0.1 0. at start of year.1 0. at end of year.1*2) 0 0 0 0 0 0 .1 0. 10 percent discount rate 1000 1000 900 740 516 270 PV.

02 0.66 . Nodhead Peer Book ROI Year 1 2 3 4 5 6 Book Income for store 1 -67 33 83 131 131 130 2 -67 33 83 131 131 3 -67 33 83 131 4 -67 33 83 5 -67 33 6 -67 Total book income -67 -33 50 181 312 443 Book value for store 1 1000 834 667 500 333 167 2 1000 834 667 500 333 3 1000 834 667 500 4 1000 834 667 5 1000 834 6 1000 Total book value 1000 1834 2501 3001 3334 3501 Book ROI for all stores -0.067 -0.06 0.018 0.91 -20.094 0.73 -216.79 -200.19 -118.126 EVA for all stores -166.96 92.

Return Rate of Return (%) 12 11 Economic rate of return 10 9 8 7 Book rate of return 5 10 15 20 25 Rate of Growth (%) . Nodhead Growth v.