Chapter 12 - Agency Problems, Compensation, and Performance Measurement

CHAPTER 12

Agency Problems, Compensation,

and Performance Measurement

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. True

b. True

c. False. Stock options give managers the right (but not the obligation) to buy
their company’s shares in the future at a fixed price.

d. True
 
Est. Time: 01- 05

2. a. Agency costs. Value lost when managers do not act to maximize value.
This includes costs of monitoring and control.

b. Private benefits: perks or other advantages enjoyed by managers.

c. Empire building: investing for size, not NPV.

d. Entrenching investment: managers choose or design investment projects

that increase the managers’ value to the firm.

e. Delegated monitoring: monitoring on behalf of principals. For example, the

board of directors monitors management performance on behalf of
stockholders.

Est. Time: 01- 05

3. Monitoring is costly and encounters diminishing returns. Also, completely

effective monitoring would require perfect information.
 
Est. Time: 01- 05

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

4. a. Dollar amount

b. EVA = Income earned – (cost of capital × investment).

c. They are essentially the same.

d. EVA makes the cost of capital visible to managers. Compensation based

on EVA encourages them to dispose of unnecessary assets and to forego
investment unless it earns more than the cost of capital.

e. Yes, applying EVA requires adjustments to the financial statements.

 
Est. Time: 01- 05

5. ROI = income / net assets

ROI = $1.6m / $20m
ROI = .08, or 8%

Net return = 8% – 11.5%
Net return = –3.5%

EVA = income earned – cost of capital × investment

EVA = $1.6m – (.115 × $20m)
EVA = –$.7 million

Est. Time: 01- 05

 
6. cash flow; economic; less; greater

Est. Time: 01- 05

 
7. Managers do not usually meet short-run earnings targets by creative accounting,
but instead by reducing or delaying discretionary advertising, maintenance, R &
D, or other expenses.

Est. Time: 01- 05

8. The typical compensation and incentive plans for top management include salary
plus profit sharing and stock options. This is usually done to align as closely as
possible the interests of the manager with the interests of the shareholders.
These managers are usually responsible for corporate strategy and policies that
can directly affect the future of the entire firm.

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Plant and divisional managers are usually paid a fixed salary plus a bonus based
on accounting measures of performance. This is done because they are directly
responsible for day-to-day performance, and this valuation method provides an
absolute standard of performance, as opposed to a standard that is relative to
shareholder expectations. Further, it allows for the evaluation of junior managers
who are only responsible for a small segment of the total corporate operation.

Est. Time: 06- 10

9. a. When paid a fixed salary without incentives to act in shareholders’ best
interest, managers often act suboptimally.
1. They may reduce their efforts to find and implement projects that add
value.
2. They may extract benefits-in-kind from the corporation in the form of a
more lavish office, tickets to social events, overspending on expense
accounts, etc.
3. They may expand the size of the operation just for the prestige of
running a larger company.
4. They may choose second-best investments in order to reward existing
employees, rather than the alternative that requires outside personnel
but has a higher NPV.
5. In order to maintain their comfortable jobs, managers may invest in
safer rather than riskier projects.

b. Tying the manager’s compensation to EVA attempts to ensure that assets

are deployed efficiently and that earned returns exceed the cost of capital.
Hence, actions taken by the manager to shirk the duty of maximizing
shareholder wealth generally result in a return that does not exceed the
minimum required rate of return (cost of capital). The more the manager
works in the interests of shareholders, the greater the EVA.

Est. Time: 06- 10

10. Shareholders are ultimately responsible for monitoring top management of

public U.S. corporations. However, unless there is a dominant shareholder
(or a few major shareholders), monitoring is generally delegated to the board
of directors elected by the shareholders. The board of directors of a large
public company also retains an independent accounting firm to audit the
company’s financial statements. In addition, lenders often monitor the
company’s management in order to protect lenders’ interests in the loans they
have extended; in the process, monitoring by lenders can also protect
stockholders’ interests.

Est. Time: 01- 05

11. Since management effort is not observable, management compensation must in

practice rely on results. The major problem introduced by rewarding results

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

rather than effort is the fact that, in the corporate setting, results are a
consequence of numerous factors, including the manager’s efforts. It is generally
very difficult, if not impossible, to precisely identify the extent to which a
manager’s efforts contributed to a particular outcome. Therefore, it is difficult to
create the kinds of incentives that are most likely to reward the manager for her
contribution, and therefore appropriately motivate the manager.

Est. Time: 01- 05

12. a. If a firm announces the hiring of a new manager who is expected to
increase the firm’s value, this information should be immediately reflected
in the stock price. If the manager then performs as expected, there should
not be much change in the share price since this performance has already
been incorporated in the stock value.

b. This could potentially be a very serious problem since the manager could
lose money for reasons out of her control. One solution might be to index
the price changes and then compare the actual raw material price paid
with the indexed value. Another alternative would be to compare the
performance with the performance of competitive firms.

c. It is not necessarily an advantage to have a compensation scheme tied to

stock returns. For example, in addition to the problem of expectations
discussed in Part a, there are numerous factors outside the manager’s
control, such as federal monetary policy or new environmental regulations.
However, the stock price does tend to increase or decrease depending on
whether the firm does or does not exceed the required cost of capital. To
this extent, it is a measure of performance.

Est. Time: 06- 10

13. Answers may vary. The issue to consider is which plan creates the most
appropriate incentive structure in terms of aligning the CEO’s motivations and
compensation with those of the shareholders. In this regard, both plans have
advantages and disadvantages. With stock-option package (a), the CEO will
be compensated if the price of Androscoggin stock increases, regardless of
whether the increase is a result of the CEO’s actions or a consequence of a
situation which is beyond the CEO’s control (such as an increase in copper
prices). On the other hand, with package (b), the CEO would be compensated
if his actions lead to the result that Androscoggin stock outperforms the portfolio
of copper-mining company shares; however, the Androscoggin CEO could also
be rewarded if the CEOs of the other copper-mining companies performed
poorly leading to the result that Androscoggin stock performs better than the
lackluster average generated by the CEOs of the other companies.

Est. Time: 06- 10

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

14. a. EVA = income earned – cost of capital × investment

EVA = $8.03m – .09 × $55.40m
EVA = $3.04 million

b. EVA = $8.03m – .09 × $95m

EVA = –$.52 million

The market value of the assets should be used to capture the true
opportunity cost of capital.

Est. Time: 01- 05

15. EVA = income earned – cost of capital × investment

EVA = $1.2m – [.15 x ($4m + 2m + 8m)]
EVA = –$.9 million

Est. Time: 01- 05

16. a. False. The biases rarely wash out, even in the steady state.

b. True. Biases in book profitability can be traced to accounting rules

governing which assets are recorded on the balance sheet and the
depreciation method applied. Economic depreciation would avoid these
systematic biases but is rarely used.

Est. Time: 01- 05

17.
Period
1 2 3
Net cash flow 0.00 78.55 78.55
PV at start of year 100.00 120.00 65.45
PV at end of year 120.00 65.45 0.00

Change in value (economic 20.00 –54.55 –65.45

depreciation)
Expected economic income 20.00 24.00 13.10

Est. Time: 06- 10

18. a. The year-by-year book and economic profitability and rates of return are
calculated in the table below based on straight-line depreciation over 10
years.

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

b. Because a plant lasts for 10 years, ”steady state” for a mature company
implies that we are operating 10 plants, and every year we close one and
begin construction on another. The total book income is $76, which is the
sum of the book income for each of the ten years. Similarly, the total book
investment is $550. Thus, the steady state book rate of return for a mature
company producing Polyzone is:

ROI = $76 / $550

ROI = .1382, or 13.82%

Note that this differs considerably from the economic rate of return, which is
8%.

Period: 0 1 2 3 4 5
Investment 100.00

Book value-end of year 90.00 80.00 70.00 60.00 50.00

Net revenue 0.00 0.00 38.00 76.00 76.00 76.00

Production costs 0.00 0.00 30.00 30.00 30.00 30.00
Depreciation 0.00 10.00 10.00 10.00 10.00 10.00
Transport and other 0.00 20.00 20.00 20.00 20.00 20.00
Book income -30.00 -22.00 16.00 16.00 16.00

Book rate of return -30.00% -24.44% 20.00% 22.86% 26.67%

Cash flow -100.00 -20.00 -12.00 26.00 26.00 26.00

PV start of year 0.00 99.29 127.23 149.41 135.37 120.19
PV end of year 99.29 127.23 149.41 135.37 120.19 103.81
Change in PV 99.29 27.94 22.18 -14.05 -15.17 -16.38
Economic depreciation -99.29 -27.94 -22.18 14.05 15.17 16.38
Economic income -.71 7.94 10.18 11.95 10.83 9.62

Economic rate of return 8.00% 8.00% 8.00% 8.00% 8.00%

Period: 6 7 8 9 10
Investment
Depreciation 10.00 10.00 10.00 10.00 10.00
Book value—end of year 40.00 30.00 20.00 10.00 0.00

Net revenue 76.00 76.00 76.00 76.00 76.00

Production costs 30.00 30.00 30.00 30.00 30.00
Depreciation 10.00 10.00 10.00 10.00 10.00
Transport and other 20.00 20.00 20.00 20.00 20.00
Book income 16.00 16.00 16.00 16.00 16.00

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Book rate of return 32.00% 40.00% 53.33% 80.00% 160.00%

Cash flow 26.00 26.00 26.00 26.00 26.00

PV start of year 103.81 86.12 67.00 46.36 24.07
PV end of year 86.12 67.00 46.36 24.07 0.00
Change in PV -17.70 -19.11 -20.64 -22.29 -24.07
Economic depreciation 17.70 19.11 20.64 22.29 24.07
Economic income 8.30 6.89 5.36 3.71 1.93
.
8.00% 8.00% 8.00% 8.00% 8.00%

Est. Time: 11- 15

19. a. See tables below. Book depreciation would be $166.80 a year based on a
cost of $1,000.81, straight-line depreciation, and a 6-year life. Hence,
economic depreciation in this case is accelerated, relative to straight-line
depreciation.

b. See tables below. The true rate of return is found by dividing economic
income by the start-of-period present value. As stated in the text, this will
always be 10%.

Forecasted book income and ROI:

Year
1 2 3 4 5 6
Cash flow 298.00 298.00 298.00 138.00 138.00 140.00
BV at start of year 1,000.81 834.01 667.21 500.41 333.60 166.80
BV at end of year 834.01 667.21 500.41 333.60 166.80 .00
Book depreciation 166.80 166.80 166.80 166.80 166.80 166.80
Book income 131.20 131.20 131.20 –28.80 –28.80 –26.80
Book ROI .1311 .1573 .1966 –.0576 –.0863 –.1607
EVA 31.12 47.80 64.48 –78.84 –62.16 –43.48

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Forecasted economic income and rate of return:

Year
1 2 3 4 5 6
Cash flow 298.00 298.00 298.00 138.00 138.00 140.00
PV at start of year 1,000.05 802.06 584.26 344.69 241.16 127.27
PV at end of year 802.06 584.26 344.69 241.16 127.27 0.00
Economic depreciation 197.99 217.79 239.57 103.53 113.88 127.27
Economic income 100.01 80.21 58.43 34.47 24.12 12.73
Rate of return .10 .10 .10 .10 .10 .10
EVA .00 .00 .00 .00 .00 .00

Est. Time: 11- 15

20. For a 10% expansion in book investment, ROI for Nodhead is given in the table
below. When the steady-state growth rate is exactly equal to the economic rate
of return (i.e., 10%), the economic rate of return and book ROI are the same.

Book income for store:

Year
Placement 1 2 3 4 5 6
year:
1 –66.80 33.20 83.20 131.20 131.20 131.20
2 –73.48 36.52 91.52 144.32 144.32
3 –80.83 40.17 100.67 158.75
4 –88.91 44.19 110.74
5 –97.80 48.61
6 –107.58
Total book –66.80 –40.28 38.89 173.98 322.58 486.04
income

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Book value for store:

Year
Placement 1 2 3 4 5 6
year:
1 1,000.81 834.01 667.21 500.41 333.61 166.81
2 1,100.89 917.41 733.93 550.45 366.97
3 1,210.98 1,009.15 807.32 605.50
4 1,332.08 1,110.07 888.06
5 1,465.29 1,221.07
6 1,611.81
Total book –1,000.81 1,934.90 2,795.60 3,575.57 4,266.74 4,860.22
income

Book ROI –.067 –.021 .014 .049 .076 .100*

for all stores

*This is the steady state rate of return.

Est. Time: 11- 15

21.
a.
Using the depreciation amounts stated in the problem, the NPV is $4,200 as shown
here:

Year 0 Year 1 Year 2

Investment -30,800
Book value end of period 30,800 16,940 0
Net revenues 23,337 22,152
Depreciation 13,860 16,940
Pretax profit 9,477 5,212
Tax at 35% 3,317 1,824
Net profit 6,160 3,388

Cash flow -30,800 20,020 20,328

NPV $4,200

b.
Cash flow -30,800 20,020 20,328
PV start of year 35,000 18,480
PV end of year 18,480 0
Change in PV -16,520 -18,480

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Economic depreciation 16,520 18,480

Economic income $3,500 $1,848

ROI 10% 10%

c.
EVA declines because of the increased depreciation in year 2 which
lowers the taxes but increases the cash flows. Thus, the decrease in
the PV of the cash flows in year 2 exceeds the decrease in year 1. The
ROI remains constant because it also accounts for the offsetting
changes in the book value.

d.

PV of EVA $4,709

Using the depreciation values stated in the problem, the PV of the EVA exceeds the
NPV of $4,200.

e.
Using straight-line depreciation:

Year 0 Year 1 Year 2

Investment -30,800
Book value end of period 30,800 15,400 0
Net revenues 23,337 22,152
Depreciation 15,400 15,400
Pretax profit 7,937 6,752
Tax at 35% 2,778 2,363
Net profit 5,159 4,389

Cash flow -30,800 20,559 19,789

NPV $4,244

Cash flow -30,800 20,559 19,789

PV start of year 35,044 17,990
PV end of year 17,990 0
Change in PV -17,055 -17,990
Economic depreciation 17,055 17,990
Economic income $3,504 $1,799

ROI 10% 10%

Given straight-line depreciation, the ROI is still10%, which equals the cost of capital.
The depreciation values originally provided are probably more representative of

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

economic depreciation than are the values derived using the straight-line method.
Economic depreciation would provide the better measure of a project’s performance.

Est. Time: 11- 15

22. The present value of this asset at the start of the first year is the $12 million dollar
investment. At the 10% cost of capital, the PV declines by $4 million per year.
Thus, the economic income each year is 10% of this value. See the table below.

Year 1 Year 2 Year 3

Cash Flow 5.20 4.80 4.40
PV at Start of Year 12 8 4
PV at End of Year 8 4 0
Change in PV -4 -4 -4
Economic Depreciation 4 4 4
Economic Income 1.20 .80 .40
Economic Rate of .10 .10 .10
Book Depreciation 4 4 4
Book Income 1.20 .80 .40
Book Rate of Return .10 .10 .10

Est. Time: 11- 15

23. a. Refer to the table in part c. Note that economic depreciation is simply the
change in market value, while book depreciation (per year) is:
[19.69 – (.2  19.69)] / 15 = 1.05
Thus, economic depreciation is accelerated in this case, relative to book
depreciation.

b. Refer to the table in part c. Note that the book rate of return exceeds the
true rate in only the first year.

c. Because the economic return from investing in one airplane is 10% each
year, the economic return from investing in a fixed number per year is also
10% each year. In order to calculate the book return, assume that we
invest in one new airplane each year (the number of airplanes does not
matter, just so long as it is the same each year). Then, book income will
be (3.67 – 1.05) = 2.62 from the airplane in its first year; (3.00 – 1.95) =
1.95 from the airplane in its second year; and so on, for a total book
income of 15.21. Book value is calculated similarly: 19.69 for the airplane
just purchased; 18.64 for the airplane that is one year old; and so on, for a

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Chapter 12 - Agency Problems, Compensation, and Performance Measurement

total book value of 189.02. Thus, the steady-state book rate of return is
8.05%, which understates the true (economic) rate of return (10%).

Start of Year
1 2 3 4 5 6 7 8
Market value 19.69 17.99 16.79 15.78 14.89 14.09 13.36 12.68
Economic depreciation 1.70 1.20 1.01 .89 .80 .73 .68
Cash flow 3.67 3.00 2.69 2.47 2.29 2.14 2.02
Economic income 1.97 1.80 1.68 1.58 1.49 1.41 1.34
Economic return 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

Book value 19.69 18.64 17.59 16.54 15.49 14.44 13.39 12.34
Book depreciation 1.05 1.05 1.05 1.05 1.05 1.05 1.05
Book income 2.62 1.95 1.64 1.42 1.24 1.09 .97
Book return 13.3% 10.5% 9.3% 8.6% 8.0% 7.5% 7.2%

Start of Year
9 10 11 12 13 14 15 16
Market value 12.05 11.46 10.91 10.39 9.91 9.44 9.01 8.59
Economic depreciation .63 .59 .55 .52 .48 .47 .43 .42
Cash flow 1.90 1.80 1.70 1.61 1.52 1.46 1.37 1.32
Economic income 1.27 1.21 1.15 1.09 1.04 .99 .94 .90
Economic return 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

Book value 11.29 10.24 9.19 8.14 7.09 6.04 4.99 3.94
Book depreciation 1.05 1.05 1.05 1.05 1.05 1.05 1.05 1.05
Book income .85 .75 .65 .56 .47 .41 .32 .27
Book return 6.9% 6.6% 6.3% 6.1% 5.8% 5.8% 5.3% 5.4%

Est. Time: 11- 15

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