advanced corporate finance fina 7330 ronald f. singer agency problems and control lecture 4 fall,...
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Advanced Corporate FinanceFINA 7330
Ronald F. Singer
Agency Problems and Control Lecture 4Fall, 2010
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Agency Problem
• The Principal-Agent Relationship Typically in a Corporation, there are what is called agents and
principals:The Agent is the “person that acts,” whereas the Principal
is the person that receives the benefits from the actions.
Typical Principal/Agent relationships:
• The Agency Problem tries to solve the natural conflict of interest that arises as a result of this principal agent problem
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Conflicts of Interest
• Reduced effort on the part of the agent• Excessive perks consumption • Empire building• Entrenchment• Risk avoidance
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Agency Problem
• How do you resolve these conflicts?– Monitoring • Stockholders • Bondholders • Board of Directors • Financial Press• SEC and other government regulators • Outside auditors
– Issues opinion regarding whether reports are consistent with generally accepted accounting standards
– Qualified or unqualified opinion
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Agency Problem
– Incentives • Provide a compensation package to managers
that try to induce them to act in stockholders’ interest• Can’t determine this directly –Difficult to separate effort from luck
• Usually this is performance (or value) based incentives –Stock options
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Agency Problem
• Problems with value based compensation – Difficult to distinguish between effort and
competence, versus luck – Could be subject to manipulation • Enron, Fannie Mae, • Stock options backdating scandal
– Compensation determined by Board• Sarbanes Oxley: SOX: Compensation Committee must
be independent directors
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Agency Problem
• The Basic problem is how do you measure performance, and how do you get information that is unbiased?
• You get what you measure
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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.
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Residual Income & EVA
• 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.
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Performance Evaluation
• How do you know if management is doing a good job or not:
• What you measure is what you get • Must consider tradeoffs of high early return
versus growth• You want to capture the economic value of
investment not book values
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Message of EVA+ Advantages
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. Present Value of EVA measures NPV and thus
consistent rewarding via EVA leads to good decisions
- Disavantages EVA does not directly measure present valueRewards quick paybacks and ignores time value of
money
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What is Economic Value Added (EVA)
EVA = Residual Income = Income earned – Income required
= Income earned – Cost of Capital X Capital InvestedNote: Earned income can be written as:
ROI X Book Value of Capital Income required can be written as:
CoC X Book Value of Capital
SO: = (ROI – CoC) X BV of Capital (see spreadsheet)
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EVA of US firms - 2003
Econimic Value Added (EVA)
Capital Invested
Return on Capital
Cost of Capital
NPV of Cash Flow
Wal-Mart Stores 4,525 79,177 12.30% 6.60% 68,380Johnson & Johnson 4,459 51,508 17.6 8.9 50,351Microsoft 4,027 24,677 29.8 13.5 29,795Merck 3,347 40,941 16.9 8.7 38,588Coca Cola 2,729 20,503 20.1 6.7 41,006Intel Corp. (57) 31,216 15.6 15.8 (395)Dow Chemical (1,503) 44,158 3.6 7 (21,448)Boeing (1,974) 50,046 2.2 6.1 (31,997)Delta Airlines (2,288) 27,238 -0.9 7.5 (30,507)Viacom (5,508) 96,515 3.5 9.2 (59,797)IBM (7,505) 108,926 4.6 11.5 (65,356)
Correlation 0.97 0.51
($ in millions)
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Summary of Performance Valuation
• Use EVA Measure• Use Economic Depreciation • Estimate Cash Flows• Estimate Economic Depreciation from above• Find EVA using existing Economic Depreciation
estimates • Then value performance on that basis