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

Agency Problems in Capital Budgeting


Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
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.
CEO Compensation (2005)
$2.500

$2.000
Thousands of Dollars

$1.500

Long-term incentives & variable bonus


$1.000
Basic compensation, benefits, & perks

$500

$0
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.
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Income Assets
Sales 550 Net W.C. 80
COGS 275 Property, plant and
Selling, G&A 75 equipment 1170
200 less depr. 360
taxes @ 35% 70 Net Invest.. 810
Net Income $130 Other assets 110
Total Assets $1,000
Residual Income & EVA
Quayle City Subduction Plant ($mil)

130
ROI = = .13
1,000

Given COC = 10%

NetROI = 13% 10% = 3%


Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital

EVA = Residual Income


= Income Earned - income required
= Income Earned - [Cost of Capital Investment]
Residual Income & EVA
Quayle City Subduction Plant ($mil)

Given COC = 10%

EVA = Residual Income


= 130 (.10 1,000)
= +$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.

EP = ( ROI r ) Capital Invested


= (.13 - .10) 1,000
= $30 million
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
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?

EVA = 30 (.10 100)


= $20 million
Answer - While the EVA is positive, the movie industry highlights a
major shortfall of EVA. It ignores the fact that no long term benefit
accrues from a movie. Thus, the positive EVA is misleading. The
project is a loser, despite its high quality subject matter.
EVA of US firms - 2005
($ in millions)

Econimic Value Added Capital Return on Cost of


(EVA) Invested Capital 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
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 1000 834 667 500 333 167
Book value at end 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 -0.067 0.04 0.125 0.263 0.394 0.782
Forecasted EVA (5-.1 *2) -167 -50 17 81 98 114
Nodhead Store Forecasts

Year
1 2 3 4 5 6
Cash flow 100 200 250 298 298 297
PV, at start of year, 10 percent
discount rate 1000 1000 900 740 516 270
PV, at end of year, 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 0.1 0.1 0.1
Forecasted EVA (5-.1*2) 0 0 0 0 0 0
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 -0.018 0.02 0.06 0.094 0.126

EVA for all stores -166.73 -216.79 -200.19 -118.91 -20.96 92.66
Nodhead Growth v. 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
(%)