financial theory and corporate policy cap 13

The Role of the CFO, Performance Measurement, and Incentive Design

THE FIRST PART OF THE BOOK developed the theory of finance from first principles-the theory of choice (utility theory) and objects of choice (investment frontiers that were constructed of uncenain choices in a multiperiod setting). The equilibrium asset pricing theories that resulted are extremely useful tools for financial decision makers at the microeconomic level and shall be used throughout the remainder of the book. Now, however, we shift our orientation to the practitioner. We take the decision maker's point of view. In this chapter, we tackle three questions. How sho.uld I measure the performance of my company vis-a-vis competitors? What drives my stock ppce? How shall I design ineentive.s to reduce the agency costs between pwner, lll!lll{l,ger,' and, gtll.er s hold,ets?. In r:remaitring pters we discuss the financial economics ofthe following questions (as well as mall others). liow much is a target company worth in a takeover? Hmv canllegally avoid taxes and how much is it worth to do so? How should J manage the mix of debt and equity to maximize the value of my firm? What dividend or sharerepurchase policy should I recommend? Is leasing better than borrowing? How do I manage my company's pension fund? How do I make deci.sions about allocating our resources abroad? How hould I manage my compap.y1s risk?

The two pansof the bboktire interactive andteffective. Whenever possible, we shall point . out where the theory of finan helps practitioners and where there are gaps--either because the theory is inconsistent with practice or where the theory simply is devoid of content to aid day-to-day decisions. Formultiperiod irfye iltlent dedsio in th ( ce o f ncmainty the developments made in the appli 18. ! re ;} t i!Yive;h:l Jlk,IJIJquSly. We seriously considered moving thatAAI nano .. boel,Jmt i t i so rondaifienW we put it up front

This chapter wjtJt, o f .the e f llllCi pfficer ( FO) of a large multibusiness,IDliJtinatioo11l COifii'WlJ}lll\ : \iide yariety o f decisions and reSP9IlSibilities':that he o r she may b a v f

I } ' i n tl}e (lotn irf Qf financial economics, for

; iamp1e, capital .

y. 0 t h clpsely lilted, but somehow missing

470 Chapter 13: The Role of the CFO, Performance Measurement, and Incentive Design

from textbooks, for example, perfonnance measurement and incentive design. Others are learned on the job, for example, investor relations and how to manage the budgeting process. So let's begin. What does a CFO do anyway?

A. (~e Role of the Chief Financial Officer In the middle of the last century, the 1950s and 1960s, the CFO was primarily a financial record keeper, in charge of internal accounts and of the company's financial reporting to shareholders and regulators. This role is still common in family-owned businesses in Asia, Latin America, Africa, and Eastern Europe. But in large multibusiness, multinational companies such as Toyota, International Business Machines, British Air, Deutsche Bank, CVRD, Telefonica, and Norilsk, the CFO is one of the top three decision makers, standing alongside the.chief executive officer (CEO) and the chief operating officer (COO), Figure 13.1 attempts to display the decisions for which the CFO may be responsible. Most finance textbooks stress the first two categories: investment and financing. However, there is an important third category, namely, managerial decisions such as performance measurement and incentive design. Let's review each category in greater detail.

Figure 13.1 Decisions for which the CFO may be responsible.

Investment decisions Large capital expenditures

Research and development Mergers and acqusitions Ownership structure Capitaleffidency Working capital

management

Management decisions

Financing decisions

B. Performance Measurement 471

Managerial decisions made by the CFO include the performance measurement of the business units of the firm, setting and reviewing budgets, designing incentives that are perf onnance com-patible, and investor relations to communicate aspirations and results to the external community. The CFO is also usually responsible for being sure that the company conforms to all regulations (environmental, health and safety, tax, agency, and legal). Other top executives from planning, budgeting, human resources, and legal staff will report to the CFO on these matters. Much of the remainder of this chapter will deal with performance measurement and incentive design.

The second area is financial decisions. The CFO is responsible for the audited financial state-ments of the firm; hence the comptroller reports to him as do the external auditors. He is also responsible for the sources and uses of funds. This means that he must recommend capital stnJ.c-ture (the mix of debt and equity) and dividend policy (the percentage of dividends paid out) to the board of directors. For this purpose, the corporate treasurer usually reports to the CFO. Closely related is the risk management function, which of course includes financial risk. The CFO is usu-ally responsible for the insurance position, the hedging position, and the net risk exposare of shareholders. He will also deal with bond rating agencies that provide an assessment of the credit

risk of the company. Also, the chief planning officer often reports to the CFO. There are many types of plans, for example, tax plans, short-term (annual and quarterly) budgets, and strategic and long-range plans.

Finally, there are investment decisions. The CFO is often responsible for reviewing all capital expenditures above a certain limit, say, $2 million. A myriad of details are involved: What methodology should be used (traditional net present value or real options analysis)? How should the cost of capital be adjusted for differences in project and country risk'? How should cash flows be defined? For firms with substantial research and development budgets, the CFO is often assigned the responsibility for final allocations. In addition to internally generated growth, most firms have a development officer in charge of mergers and acquisitions, joint ventures, and divestitures, who reports to the CFO. Closely related are issues that affect the ownership structure of the firm-dilution of ownership value, violation of debt covenants, equity carveouts (initial public offerings of ownership in a business unit), issuance of tracking stock (whose value is based on the income of a business unit), and issuance of executive stock options. Finally, there is working capital management (inventory, payables, and receivables policy).

The remainder of this chapter covers performance measurement, budgeting, communicating with the external investment community, and incentive design. The remainder of Part II of the book covers most of the other topics.

B. 9erforrnance Measurement 1. Measures Based on Earnings

Performance measurement is one of the most important management responsibilities of the CFO because it subtly affects the way people behave. Owners of the firm want perfonnance measures to be aligned with maximizing shareholder wealth, a goal that is easy to articulate but difficult to implement.

Figure 13.2 defines a wide variety of performance measures that companies can use. Choice of the one to actually use is not immediately obvious. Let's go through them one by one. First, we have earnings per share or growth in earnings per share. It suffers from every knock-out criterion. It contains no balance sheet information-a deficiency that implies that if one firm requires two


Figure 13.2 Comparison of perfonnance metrics. ...

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Earnings per share EPS =NII Number of shares Growth in earnings per share G(EPS):: (EPS1-EPS1_ 1) /EPS1

--

Return on invested capital ROIC = EBIT II Return on equity ROE=NI/E Spread ROIC WACC

EP (ROIC WACC)I Economic Profit or EV A Grow1hinEP (EP1-EP1_ 1) /EP1_ 1

---

Expectations-Based-Management EBMTM = Actual EP - Expected EP --

Discounted Cash Flow DCF ---

Real Options Analysis ROA Most complicated measure

dollars of capital to generate one dollar in earnings while at the same time another requires only one dollar of capital to produce the same earnings, then the market would assign the same value to both because !;hey report identical earnings. Take a look at Figure 13.3 for an example.

The first company, called Longlife, invests $3,000 every three years in equipment that lasts three.years. The other company, called Shortlife, invests $1,000 every year. They also have timing diffr-rences in working capital investments, but other than that they are identical. They both are assumed to have a 10% cost of capital. In particular, their net income is exactly the same each year. Therefore, if one were to believe that value depended only on net income, then they should have the same value.

We have already shown, in Chapter 2, that value depends on discounted cash flows (net income plus depreciation minus capital expenditures minus investment in working capital). Although the undiscounted total cash flows are $1,800 for both companies, there are significant timing differences. Consequently, the DCF value of Longlife is $808, while for Short1ife it is $1,296-a 60% difference. This clearly illustrates why net income or earnings per share is an inadequate performance measure.

Another problem is that earnings is short tenn in nature. We once sat in a division manager's office while she received a phone call from her CEO asking that her division supply more fourth-quarter earnings so that the firm could meet its year-end consolidated earnings target. After hanging


Figure 13-3 Two companies with identical earnings but a 60% difference in value.

Longlife 2 3 4 5 6 Total

Revenues 4,000 4.000 4.000 4,000 4.000 4.000 24.000 Cash costs 2,000 2,000 2.000 2,000 2.000 2,000 12.000 Depreciation 1,000 1,000 1,000 1,000 1,000 1,000 6,000 Taxes@ 50% 500 500 500 500 500 500 3,000

Net income 500 500 500 500 500 500 3,000

Capital expenditure 3,000 0 0 3,000 0 0 6,000 Increase in working capital 600 50 50 300 100 100 1.200

Cash flow -2,100 1,450 1,450 1,800 1,400 1,400 1,800

Discount factor .909 .826 .751 .683 .621 .564 Present value -1,909 1,198 1,089 -1,229 869 790

Value of Longlife given 10% cost of capital = 808

Shortlife 2 3 4 5 6 Total

Revenues 4,000 4.000 4,000 4,000 4,000 4,000 24,000 Cash costs 2,000 2,000 2,000 2,000 2,(X)(J 2.000 12.000 Depreciation 1,000 1,000 1,000 1.000 1.000 1.000 6,000 Taxes@ 50% 500 500 500 500 500 500 3,000

Net income 500 500 500 500 500 500 3,000

Capital expenditure 1,000 1,000 1,000 1,000 1,000 1,000 6.000 Increase in working capital 200 250 250 100 200 200 1,200

..... -~--

Cash flow 300 250 250 400 300 300 1800

Discount factor .909 .826 .751 .683 .621 .564 Present value 273 207 188 273 186 169

Value of Shortlife given 10% cost of capital = 1,296

up the phone she remarked that she would supply the earnings by slashing advertising expenses, but would lose customers during the following year and would have to pay great expense to win them back. Although she believed the dictum from above would destroy value, ~he did in fact produce the required extra earnings. Finally, as we shall soon see, neither earnings per share nor the growth in earnings per share is highly correlated with the total return to shareholders.

2. Measures Based on Rates of Return Return on invested capital (ROIC) is comprehensive because it is the product of two key value drivers (operating margin and capital turnover). The definition of pretax ROIC is

EBJT sales ROJC:::: - x ----sales invested capital

(13.1)


Figure 13-4 ROIC tree.

x

Operating margin = Operating profit I sales

ta! turns= sales I invested capital

Physical capital +

Operating cash +

Inventories +

I Accounts receivable

Accounts payable

Materials cost

Energy cost Number of sales personnel

Sales force Compensation package

Staff Sales per salesperson

Capacity utilization

Design specifications

Credit policy per product line

Delinquent accounts

Method of payment

where EBJT is earnings before interest and taxes. When used to evaluate business unit performance, however, ROIC encourages capital harvesting behavior. It is easier for a manager to allow the capital under her control to depreciate than it is to invest new capital profitably. As she harvests the business, ROIC rises because the amount of invested capital is assumed to drift upward. What happens, however, before much time passes, is that the capital base devalues and, assuming that the decline in sales is not as bad as the decline in the capital base, then ROIC will be fine. The spread of the ROIC over the w~ighted average cost of capital (WACC) has the same problem. Management cannot influence WACC, so the easiest thing to do to raise ROIC is to allow the base of invested capital to depreciate-that is, to harvest the business.

As part of expectations-based management, however, ROIC is useful because it traces back into all of the line items in the income statement and balance sheet as shown in Figure 13.4. It is possible to trace individual lines on the financial statement all the way down to individual product line information for the purpose of performance measurement.

Return on equity (ROE) is also a poor performance measure. First, it is possible to artificially raise the return on equity by using 100% debt to purchase another company that earns less than its cost of capital but more than the cost of debt The result will be to increase the return on equity, but to increase risk faster, thereby decreasing the price per share of the company:

ROE= (EB/T-kbD)(l-T)/E, (13.2)

where

B. Performarice Measuremerit 475

k1, == the interest rate good on the face value of debt,

D the face value of debt. T the cash tax rate, E == the book value of equity.

3. An Economic Profit Measure The definition of EVA, a trademark of Stern Stewart, also called economic profit (EP), is the spread between the return on invested capital (ROIC) and the weighted average cost of capital (WACC)multip!ied bythedollaramountofinvestedcapital (l).EP = EVA = (ROIC - WACC)l. It helps to alleviate harvesting behavior by multiplying the spread by the amount of invested capital. One often reads that when economic profit is positive, that is, when a business unit earns more than its weighted average cost of capital, the business unit in question creates value for

. shareholders. It turns out that positive EVA is neither a necessary nor sufficient condition for creation of shareholder value either at the company or the business unit level. Furthermore, the level of EVA as well as the growth in EVA are not highly correlated with the total return to shareholders (TRS). More detail will be given shortly. Perhaps an example will sutlice in the meantime. In October 1998, Intel, a computer processor manufacturer. which was earning roughly 50% return on invested capital. and which had a cost of capital equal to roughly 10%. reported that its earnings were up 19% over the year before. Clearly, Intel's EVA was positive, as was its growth in EVA. Yet on the announcement, its share price fell 6%. Why? Because the consensus analyst expectation was that earnings were to have gone up 24%. Hence. expectations were not met, and Intel's price was adjusted downward. EVA does not attempt to incorporate expectations.

Chapter 14 shows that the discounted value of EP. when added to the book value of assets in place, equals the DCF value of the firm. A short example is shown in Table 13.1. Either way. whether we look at DCF orat discounted EPplus assets in place. the value of the entity is $1.088.60. Given this value, the expected return to investors is 10% (i.e., WACC). To create value in year I, for example, EP must exceed the $50 that is expected, or EBIT (I T) must exceed $150. The same requirement is true for any and all years. For example, in year 2 if EBIT (1 T) turns out to be $200 instead of $220, the value of the firm will fall, even though ROIC > WACC and EP is positive.

4. Measurement Based on Expectations To create shareholder value it is necessary and sufficient for a company or a business unit to exceed shareholder expectations. As shown in Figure 13.2, expectations-based management (EBMr" is a trademark of the Monitor Group) is defined as the difference between actual and expected economic profit:

Actual EP Expected EP == [Actual ROIC - Expected ROICJ x l [Actual WACC Expected WACC] x I

+ [ROIC WACC][Actual I Expected I]. (13.3)

Equation 13.3 has three parts. The first may be interpreted as earning more than expected on the company's invested capital,/. The second says that value is created when the actual cost of capital is lower than the expected cost of capital. The third term says value is created when the company


Table 13.1 Comparison of EP with DCF for Valuation After-tax Discount

Year ROIC EBIT(l - T) WACC EP FCF Factor PV(FCF) PV(EP) 0 $1,000 10% 1.000 $1,000.0

15% $1,100 $150 10% $50 $50 0.909 $45.5 $45.5 2 20% $1,300 $220 10% $110 $20 0.826 $l6.5 $90.9 3 10% $1,400 $130 10% $0 $30 0.757 $22.5 $0.0 4 5% $[,800 $70 10% -$70 -$330 0.683 -$225.4 -$47.8 5 10% $2,000 $180 10% $0 -$20 0.621 -$12.4 $0.0

CV 10% $200 10% $0 $2,000 0.621 $1,241.8 $0.0

$1,088.6 $1,088.6

Notes: gcv 5.0% (continuing value growth) FCF free cash flow EBIT (I - T) - changes in new (J) investment CV= continuing value EBIT (1-T)(I- gcy/r)/(WACC- gcv)

$200(1- .05/.10)/(.1 - .05) = $2,000 I= book value of assets

WACC l 0% ( weighted average cost of capital)

invests more than expected and does so profitably. In other words, it earns more than the cost of capital on new capital invested. Overall, expectations-based management is the best short-term measure of management performance. It is also the measure that is most highly correlated with the total return to shareholders.

Table 13.2 shows the results of regressions where the annual market-adjusted total return to shareholders is the dependent variable and the independent variables are the earnings per share (EPS) .scaled by the share price at the beginning of the year in the first row, the growth in EPS scaled by the beginning-of-the-year share price in the second row, the economic value added (scaled) in the third row, and the growth in economic value added (scaled) in the fourth row. The sample was taken from the S&P 500 for the years 1992-1998. None of the r-squared statistics exceed 6%, although according to the i:statistics that are shown in parentheses, all of the independent variables are statistically significant.

Table 13.3 brings analyst expectations into the picture. As before, the dependent variable is the total return to shareholders, adjusted for the market return the same year. The equation for the market-adjusted return, MARi,,

MAR _nn+ JI -

CT( I+ 'm,) ( 13.4)

takes the ratio of the product of the one-month returns for the ith stock in a given year and divides it by the product of the monthly market returns in the same year. This is then regressed against three expectations-based variables in the following structural equation:

MAR;1 =a+ b ln[E(l, 1)/ E(l, 0)]+ cln[E(2, 1)/ E(2, 0)]+ d[E(L, I) - E(L, O)]+ E11 (13.5)


Table 13.2 Market-Adjusted Total Return to Shareholders and One-Period Return Measures A B c D

Intercept -0.099 -0.0441 -0.003 -O.lJ04 (14.02) (-8.33) ( 5.59) (-6.871

EPS,/SH J.086 (12.89)

!::,,PS,/S1_ 1 0.669 (11.10)

EVA/S1-1 0.001 (6.786)

!::,,VA/S1-1 0.003 00.02)

Number of observations 2,582 2.579 2,194 2.185 Adjusted R-squared 0.06 0.05 O.D2 0.04 F-statistic 166.1 123.3 46.1 100.4

Source: Copeland, Dolgoff, and Moel (2003) Panel data forthe S&P 500 compar.ies for the years 1992-1998. EVA data from Stem Stewart. Company EPS and EPS growth data from Compustat, market return data from CRSP. 1-stntistics in parentheses.

The first term is analyst expectations about this year's earnings as revised this year (between time O and time 1 ). The second term is the revision of analyst expectations of earnings next year, but observed this year. In other words it is the difference between analyst expectations of next year's earnings at the end of this year versus the expectations of earnings next year at the beginning of this year. The natural logarithm of the first two tenns is used because the data are supplied in units of dollars per share and we wanted to convert to percentages. The third term, the change in expectations about long-term growth as observed this year, was already given as a percentage. The results of this multiple regression are given in Table 13.3.

In this regression the r-squared is 47% when all variables are included (column I). When only two independent variables at a time are included, the lowest r-squared is 28%. Clearly, the total return to shareholders and changes in analyst expectations are closely related with each other. Upon further examination, the first column of Table 13.3 tells us that there is no significant relationship between changes in expectations this year about this year's earnings and TRS, when longer-tenn expectations are also in the multiple regression. However, changes in expectations this year about next year's earnings and about long-term earnings growth are both highly significant. Even more interesting is the fact that the impact of changes in expectations regarding long-tern1 growth (3.269) is 8.4 times larger than the impact of changes in expectations about earnings next year. If the value of a company in the market is conceptuaiized as a discounted cash flow, the multiple regression makes perfect sense because most of the value is derived from cash flbws beyond the first two years.

So far we have only looked at changes in earnings expectations. What about the cost of capital and capital expenditures? They also appear in Eq. (13.3). Unfortunately, most analysts do not record their expectations about these two additional variables. Therefore, we have to build our own expectation models. The CAPM was used to estimate the difference between the beginning and end-of-year cost of equity and that was assumed to be the change in expectations about the cost


Table 13,3 Market-Adjusted Total Return to Shareholders and Changes in Analyst Expectations A B c D

Intercept 0.360 0.430 0.420 0.461 (18.108) (19.81) (18.88) (20.74)

ln[E(l, 1)/E(I, 0)) O.Dl8 0.324 (0.94) (22.25)

ln[E(2, 1)/ (2, 0)] 0.389 0.280 (18.22) (23.25)

E(L, 1) E(L, 0) 3.269 4.105 (16.08) (19.79)

In(!/ S1_ 1) 0.117 0.142 0.139 0.159 (18.82) (20.80) (19.88) (22.85)

Number of observations 2,318 2,491 2,365 2,560 Adjusted R-squared 0.47 0.31 0.32 0.28 f-statistic 512.9 567.7 562.1 489.3

!\0111re. Copdand. Dolgoff, and Moel (2003). Panel data for the S&P 500 companies for the years 1992-1998. fapeclation, uala frum Zach, market return data from CRSP. I-statistics in parentheses.

of capital. Changes in expectations about capital expenditures were estimated by calculating the difference between actual capital expenditures as a percentage of sales and capital expenditures predicted by a simple time-series regression based on the last five years of history. The results. shown in Table 13.4, indicate that percentage changes in expectations of the cost of equity ks,t+I are statistically significant and have a negative sign as predicted. Unexpected changes in capital expenditures, however, are not significant.

What are the implications of expectations-based management for CFOs? First of all, perfor-mance of business units must exceed expectations in order to create shareholder value. Consider the following example. Two business units have the same cost of capital, let's say 10%. During the past year business unit A earned 8% ROIC and business unit B earned 15%. Which created more value for shareholders? The answer is that we cannot make any judgment unless we know what the business units were expected to earn. If, for example, unit A was expected to lose 5%, then it has exceeded expectations by 13% and created shareholder value. On the other hand, ifunit B was expected to earn 25%, then it has fallen short of expectations by 10% and destroyed shareholder value. Slightly more subtle are decisions that involve new investment. Again, let's take a simple example. Suppose that a company has informed the market that it has two new investments, each expected to earn 30% while the cost of capital is 10%. The market believes what it has heard and incorporates the good news into the share price, which has risen as a consequence. Suddenly, management learns that one of the two projects will earn only l 5% instead of the expected 30%. Should management cancel the new project? This is a thorny problem, requiring careful thought. If management does proceed to undertake the project, then the market's expectations will be revised downward and surely the stock price will fall. Remember though, that every decision in economics must be weighed in light of the next-best alternative, which in this case is deciding not to go ahead with the 15% return project If management decides not to invest, then shareholders are presumed to earn exactly the opportunity cost of capital, namely, 10%. Consequently, if the 15% project


Table 13-4 Market-Adjusted Return and Expectations, the Cost of Equity, and Capital Expenditures Independent Variable A B c D E F G

Intercept 0.009 0.360 0.359 0.358 0.359 0.361 0.361 (2.23) (!8.11) (17.73) ( 17.96) (17.74) (1333) i13.67)

ln[E( I. 1)/ E(l, OJI -0.006 0.018 0.026 0.017 0.026 0.01 i 0.007 (-0.34) (0.94) (l.39) (0.92) (l .37) (0.48) (0.33)

ln[E(2, IJ/ (2, O)] 0.465 0.389 0.391 0.391 0.390 0.416 0.421 (22.30) (18.22) (18.19) (18.28) (18.15) (15.89) ( 16.26)

E(L, I) - E(L, 0) 3.492 3.269 3.263 3.273 3.260 2.771 2.679 (17.73) (16.08) (15.27) (16.10) (15.27) (I 0.36) (10.38)

ln(l/Sr-1) 0.117 0.118 0.118 0.118 0.123 0.123 (18.82) (18.60) (18.83) (18.59) (14.70) ( 15.06)

(kr+I - kr)/ k1 -0.087 -0.014 (-2.30) (-0.30)

(rJ;r+l (r1.r+1))/ E(rr,+1) -0.036 (-1.53)

(/Jt+J /31)//3, -0.128 (-2.99)

UCAPEX -0.002 --0.002 (-0.38) (-0.40)

Number of observations 2,699 2,318 2,185 2,318 2.185 1,384 L457 Adjusted R-squared 0.38 0.47 0.48 0.47 0.48 0.47 0.47 F -statistic 558.7 512.9 403.8 411.0 405.2 206.0 254.6

Source: Copeland, Do!goff, and Moel (2003). Panel data for the S&P 500 rnmpanies for the years 1992-1998. k, is the n,D.rket cost of equity. 11.,+1 is the ;1cmJl lO-year Treasury spot rate at the end of the year, E (r f.r+ 1) is the one year forward I 0-year rate as of the beginning of the year. Betas are BARRA betas. UC.4PEX stands for scaled unexpected capital expenditures. Expectations data from lacks. market return data from CRSP. I-statistics in parentheses.

is rejected, shareholders will earn only 10% and the stock price will fall even more. Therefore, when it comes to new investments, the rule of thumb remains the same as in Chapter I. Maximi:e shareholder wealth ljy accepting all new investments that earn more than the market-determined opportunity cost of capital.

Figure 13.5 shows a chart with data for Chevron, one of the world's largest integrated oil companies from 1990 to 2000. Notice that in 1994-95 earnings rose from approximately $2.50 per share to $3.00 per share. Nonnally, we would expect this to be good news, but the total return to shareholders, relative to the market, fell the whole year. The rationality of this is difficult to understand until analyst expectations are plotted on the same chart. The squiggly line that starts in January 1993 and ends in the square earnings box in December 1995 represents consensus analyst expectations. In January 1993 analysts were expecting about $3.50 per share for 1995. During the two years that followed they continuously reduced their expectations, and it was this downward revision that matched the decline in the market-adjusted total return to shareholders. Note also that during 1995, expectations of earnings the following year (1996) were also adjusted downward, although in early 1996 they began to turn around.

480 Chapter 13= The Role of the CFO, Performance Measurement, and Incentive Design

Figure 13.5 Chevron 1990-1998:TSR,annual earnings, and market expectations. Source: Monitor Analysis, Zacks, Compustat.

Chevron Corp. Market-adjusted TSR vs. analyst earnings estimates, 1991 1998

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5 l.2

4.5

4 [/) Gl 3.5

3

2.5

2 Note: EPS and analyst expectations 02 exclude extraordinary items

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The art of setting expectations requires that management communicate appropriately with investors in the market place, and formulate and monitor performance vis-a-vis expectations internally. Let's discuss external communications first. Define the signal-to-noise ratio as

SNR = [actual EP - expected EP]/a(analyst). (13.6)

The signal, in the numerator, is the difference between actual and expected economic profit. Noise, in the denominator, is the dispersion of analyst expectations (measured by the standard deviation).

For a given strength signal, we hypothesize that as the amount of noise increases, there will be three effects. First, greater noise implies greater variation in the resulting message, namely, the total return to shareholders. Second, the reaction of share prices to any single message becomes smaller because the information in the message becomes obscured by the noise. For time-series data these two effects will be difficult if not impossible to separate. The third effect is the relationship between the signal-to-noise ratio and the level of TRS. Since greater noise implies greater variance in TRS and greater difficulty interpreting the signal, we expect that the m.irrket will require higher returns on average in order to be compensated for poorer-quality signals. The conclusion is that if management seeks to maximize shareholder wealth, it should attempt to reduce noise when communicating with the market. In practice this implies an unbiased signal. If there is a bias ( e.g., consistently setting expectations lower than management expects it can achieve), and if the bias is constant, then the market simply adjusts for it and the resulting signal is the same as if there had been no bias at all. The opposite is an uncertain bias-sometimes pessimistic and at other times optimistic. This lack of constancy results in a noisier signal and consequently a lower share price as investors require a higher expected return.

Not only is it advisable to have an unbiased signal, but it is wise to pay attention to other attributes. If multiple members of the top management team are responsible for communicating with the market, their messages should be mutually consistent-to reduce noise. The messages should be verifiable through independent sources (such as customers, suppliers, competitors,


regulators, and former employees of the company). And there should be "color" to the signal. In other words it should contain in-depth explanations for what is being communicated.

The complement to external communications with investors is the process of building and monitoring internal performance expectations. Finally. it is desirable to align compensation with performance-a topic thar is discussed in greater detail later in this chapter. Usually the budgeting process is the way that expected performance is established and monitored. Without delving far into an unnecessary level of granularity, it is worth simply stating a few rules of thumb that set apart good from bad budgeting practices:

1. Redo the budget whenever the operating environment changes. 2. Work to set reasonable stretch targets. 3. Assign decision rights to the people who have the right skills and necessary information. 4. Don't overreach a manager's span of control. 5. Be aware that the process of setting expectations is not necessarily incentive compatible with

actual performance. 6. When decision rights are assigned, be sure to assign responsibility and accountability with them. 7. Be aware of externalities among business units and seek market-based solutions. 8. Be aware of multi period problems with measuring performance and designing incentives.

The first of the eight rules of thumb is almost always violated by bureaucrats who insist that budgets be submitted at the same time each year whether revision is needed or not. The reality is that when information anives that materially changes the opportunity set facing a company. then it is time to revise the plans that are embedded in the budget and to resubmit. An annual budgeting cycle is meaningless most of the time. Rules 2 and 5 are closely related. Michael Jensen [2002] has been quoted as saying that "the budgeting process is just an incentive for lying: The logic is straightforward, but not compelling. Lower-level management has an incentive to set cxoectations low-low enough that it becomes easy to surpass easy benchmarks-a process called sandbagging. There are two ways to overcome this problem. The first is to be better informed. In order to have a two-way discussion between top management who must set expected performance standards, and lower-level management who must perform, it becomes necessary for top management to take the time and effort to understand the business that they are evaluating. Critical information may be gathered from former managers of the business, from suppliers, from customers, from engineers. and from government agencies. An informed discussion helps to reduce sandbagging. The second piece of advice is to create an incentivi;-compatible compensation design. There is more on this point later on in the chapter. Rules 3, 4, and 6 are also related. Together they imply that the manager of a business unit should have complete control over its resources. For example, a performance measurement system based on earnings assigns no responsibility for managing capital efficiently. It is hardly surprising that when managers are not charged for using the firm's capital, that the sales revenue per dollar of capital employed begins to decline. Rules 7 and 8 are easy to state but difficult to implement.

5. Measurement Based on DCF Valuation The main shortcoming of all of the aforementioned perfonnance measures is that they are basically one-period views of the world. Consequently, at the corporate level and the business unit level, where it is reasonable to assume that forecasts of both the income statement and of the balance


sheet information are available, it is advisable to take a look at discounted cash flow valuations. The expected cash flows in these models might be based on analyst forecasts and provide a market perspective of the company's value, or they might be based on management forecasts to provide an inside-out perspective. If the difference between the two is significant, it may lead to board-level decisions. For example, if the market value is less than management believes the stock is worth, then a share repurchase program can be initiated.

Because valuations are multiperiod in nature, they are also useful for setting one-period per-formance targets, when one is using an expectations-based management system. To create value it is necessary to exceed expectations, and these are not always constant over the life of a busi-ness unit. Often there is a start-up period following a major capital expenditure when the expected ROJC is low or negative, followed by a normal return period, followed by higher expected returns when the capital base depreciates. If these life cycle stages are predictable, then it is not diffi-cult to set expectations of performance in an appropriate manner. A similar story can be told for tum-around activities and cyclical businesses. Still other businesses perpetually earn high ROIC because they do not use much capital, for example, a consulting firm. In all instances, the mul-tiperiod a,;pect of DCF is useful when used in conjunction with the short-term measures listed earlier in the chapter.

6. Measurement Based on Real Options Real options analysis is a superset of DCF, and all that was said there is applicable here. Most companies gain insight from ROA primarily at the project level, although decisions concerning whether to exit and reenter a line of business, and certain aspects of mergers and acquisitions (the option to expand or abandon an acquired business), are common applications.

This section discusses the design of incentive systems. Given that there is often a separation of ownership from the control of operations, how can incentive design help to alleviate the resulting agency cost? For example, you might own a farm, but fail to possess the farming skills necessary to own it: Naturally, you hire a farmer to run the day-to-day operations. How should you compensate her? If you use a form of profit sharing, the farmer will maximize this year's crop output. But as owner that may not be in your best interest because it requires overfarming the land and therefore exhausting it for future use. The result is that there is a conflict between maximizing this year's crop yield and maximizing the value of the farm for resale.

There is a short list of thorny issues in incentive design. First, how should pay be linked to performance, given the objective of shareholder (i.e., owner) wealth maximization? Second, given that executives change jobs frequently, how should compensation be distributed over time? Third, how should incentive design vary between line officers and staff, and as one moves from top management to middle-level management and lower'?

1. Why Maximize Shareholder Wealth? Before diving into these topics, there is first the question of why it makes sense to organize resources into corporations with a limited liability residual claimant called the shareholder. Why not organize as an Athenian democracy where all stakeholders can vote on policies and decisions, or into an

C. Incentive Design 483

autocracy run by an absolute dictator, or into a socialist firm where all ownership rests in the hands of workers who are represented by decision-making committees? The broad answer is that a firm may be thought of as a set of contracts designed to share risk and maximize output. As residual claimants (with limited liability) the shareholders need to satisfy all other higher-priority claimants and to accept all residual risk. In order to maximize their own wealth, shareholders must be sure that customers are well cared for, that the appropriate labor force can be recruited and retained, that suppliers are content, that bank covenants are adhered to, that interest and debt principal payments are made as promised, and that the government receives the taxes that are due. Suppose that there were no residual claimant to whom decision rights are assigned. If so, then stakeholders with limited information might take the helm. For example, employees who are typically risk averse find it difficult to separate the risk of their human capital (e.g., losing their jobs) from risk taking in business and, consequently, they might be overly conservative decision makers. The assignment of residual risk to shareholders who are free to sell their shares in an open market and free to spread their company-specific risk across diversified portfolios, and who do not have their human capital tied up in the corporation, results in efficient risk sharing. The fact that they have control of the company that they are said to own gives them decision rights that are aligned with the interests of all of the stakeholders ahead of their residual claim.

Jensen [ 1998] adds four related attributes to these basic themes. First, when risk changes over time (as it always does), then it is costly to write and rewrite contracts for sharing rules among the diverse claimants of the firm. Second, shareholders who are not employees. and who are granted limited liability by the government, find that it is easier and less cost! y for them to bear the company risk than it is to write detailed contracts regarding risk sharing. It has been argued that common stock (i.e., wealth from residual claimants) is ideal for outright ownership of assets by a firm. having lower transactions costs than rental contracts for use of the same assets. Third, residual claims that are alienable (i.e., that can be sold and bought) make it easier to separate ownership from control. This, in turn, makes it easier to hire managers with firm-specific skills because they are not required to tie up both their human and their financial capital under the roof of the firm for which they work. Finally, the existence of shares as residual claims does not hamper decision making of management because the separation theorem discussed in Chapter I of this textbook can be applied-namely, take all projects until the marginal rate of return on the last dollar spent just equals the market-determined cost of capital.

Often it is alleged that the existence of residual claims held by shareholders creates conflicts with other stakeholders, especially labor. The allegation is that greater profits for shareholders are obtained by laying off labor. Copeland, Koller, and Murrin [ 1994] study the relationship between employment growth and shareholder wealth creation. over the 1983-1991 time interval. Their sample is collected at the company level and aggregated by industry in three countries: Japan, Germany, and the United States. They find no evidence that labor suffers to benefit shareholders. Within an industry, and in the long run, companies that are winners are more productive, create more shareholder wealth, and experience greater growth in employment. In the auto assembly industry, for example, all countries experienced growth in employment, but the Japanese, who were the most productive, had the greatest growth in employment. Similarly, in steel, an industry with overcapacity and shrinking employment due to technological changes, Germany had greater shareholder wealth creation and better employment results than the United States. The empirical evidence clearly indicates that creating an organization where residual claims and control of the company both are held by shareholders actually aligns the economic interests of all stakeholders. All are afloat in the same ship, and prosper or sink with it.


2. Alignment of Pay with Performance The first half of this chapter makes a strong case that the performance measure most closely related to the total return to shareholders is the difference between actual and expected (i.e., forecasted) results. This is without doubt a subjective measure, and it becomes necessary to deal with its subjectivity. Jensen [1998, p. 206] argues that "performance in most jobs cannot be measured objectively because joint production and unobservability mean that individual output is not quantifiable." He goes on to criticize objective merit systems because ( 1) any misspecification of the performance mea~urement system can be easily gamed by employees, (2) the measurement system becomes difficult to change because inevitably any alteration is detrimental to some employees, and (3) the threat of increasing objective standards higher in response to better-than-expected performance this year-the so-called expectations treadmill-causes a behavioral reaction where employees deliberately restrict output so that they can earn their bonuses. There are reasons against subjective systems as well. Subjective systems are unpopular because employees may not trust superiors to evaluate their performance accurately. Given the negative attributes of objective systems and the lack of trust that defeats subjective systems, Jensen concludes: 'The compensation system that results from this set of forces appears to be one with little or no pay for performance."

There are, however, some basic principles that help to link pay with performance. The first is to keep the relationship between performance and compensation as linear a~ possible. Figure 13.6 illustrates a "kinked" relationship between pay and performance that is typical. Although the relationship is linear around the average or expected level of performance, there is a lower bound represented by basic salary, and an upper bound that represents salary plus maximum bonus. To understand how the kinks in the curve, combined with the one-period nature of compensation, result in perverse behavior, suppose that a manager finds herself at point A on the curve near the end of the year. It makes sense to take large risks because she cannot do worse on the downside, and if the risk pays off she can earn much more on the upside. If we study her behavior at point B instead, and if it is early in the year, then from her point of view she is incented to be very conservative because she can lose a lot on the downside and gain little on the upside because she is already at the maximum bonus point. Clearly, a linear pay schedule is much better because she gets a constant percentage of the value created through her actions. By the way, we note that if performance is measured relative to expectations, it is just as easy to construct a linear pay schedule.

Figure 13.6 "Kinked" relationship between pay and performance.

Pay Linear incentives

B

I Kinked incentive structure J i // \ ~~"'"' to be,ttraconsm,ti,c _______ A/ { I . ______ ""_Pr_o_pe_n-si-ty_t_o_ta-ke_l_ar_g_e __ "~l1tornlanice :1 _ risk at thmd of the Y'" "


3. The Use of Stock Options It is often argued that if enough of an executive's wealth is tied to the performance of the company, then there is no agency problem between the owner and the managers of the firm. The manager will want to join the owner in seeking to maximize the value of the stock. Some would say that the manager should invest a substantial portion of his wealth in the stock or in call options on it to align the manager's interests with their own. An executive stock option plan is a form of long-term compensation contract that depends on corporate performance. It usually gives managers the right to purchase a specified number of shares for a specified period of time (called the maturity date of the option) for a specified price (called the exercise price). The first stock option plan to receive favorable tax treatment was called the Restricted Stock Option plan of the Revenue Act of 1950. There have been many changes since then, but since 1994 the tax laws govern two types of plan: incentive stock options (ISOs) and nonqualified stock options (NQSOs).

Tax consequences are as follows: At the time of the grant there are no tax consequences for either the executive or the company. At exercise, the executive who was granted NQSOs pays the ordinary income tax on the spread (Sx - X) between the stock price and the exercise price; the company reduces X and can deduct S - X. When the stock is sold, the executive pays a capital gains tax on Sr - S x, and there is no consequence for the company. If the executive was granted an ISO, taxation is deferred until the stock is sold, when the capital gains rate is applied to Sr S0, the gain from the time of grant, and there is no tax consequence for the company.

The accounting treatment is also important. Both NQSOs and ISOs must be exercised sequen-tially. There is a definite drawback to the sequential exercise requirement. Suppose the firm's share price was $50, fell back to $30, then rose again to $40. If options were issued at each stage with the exercise price equal to the stock price, executives would be required to exercise the earlier $50 options (that are $10 out-of-the-money) before they could exercise the options that were issued at $30 (that are $10 in-the-money).

Both ISOs and NQSOs have a maximum life of l O ye:m from the date of issue. The exercise price ofISOs must be greater than or equal to the stock price at the time of issue, but NQSOs can have an exercise price as low as 50 percent of the stock price.

Two reasons for using stock options at all are ( 1 )that they augment salaries with a call option that makes executives' total compensation more closely tied to shareholder wealth creation and (2) that stock options are a more tax-efficient way of delivering after-tax dollars to executives. Nevertheless, options pay off on the upside and are simply left unexercised on the downside; consequentially they are part of a compensation schedule that is "kinked" on the downside. However, it can be argued that the practice of resetting the exercise price after the stock p;:ice declines has the effect of straightening the kinks, for example, cash payments.

Miller and Scholes [1982] demonstrate that, when compared with salaries, options are tax neutral from the firm's point of view and are tax dominant from the manager's point of view. To illustrate their argument, suppose that a firm expects $140 million of cash flow in a good state of nature before paying management salaries, and $120 million in a bad state. The finn' s tax rate is 50%, and management salaries amount to $100 million. Table 13.5 shows the firm's net payoffs after management salaries and taxes.

If the probability of the good state is 50% and if we assume a zero discount rate, then the present value of the firm in this one-period example is $15 million. Assume IO million shares outstanding so that the price per share is $1.50. An at-the-money call option will sell for $0.25, the average of its good and bad state payouts, as shown in Table 13.6.

486 Chapter13: The Role of the CFO, Performance Measurement, and Incentive Design

Table 13,5 Expected Cash Flows of the Finn (millions of dollars) Good State Bad State

Cash flow before salaries $140 Salaries -100

Cash flow before taxes 40 Taxes@ 50% -20

Net cash flow $20

Table 13.6 Call Option Payouts at Time 1

Share price Less _the exercise price

Payout

Good State

$2.00 -1.50

$0.50

Table 13.7 Subsidiary Balance Sheet (millions of dollars)

$120 -100

20 -10

$10

Bad State

$1.00 -1.50

$0.00

Beginning Good State Bad State

Assets $15 Debt $12.5 Assets $15 Debt $15 Assets $10 Debt Equity 2.5 Equity 0 Equity

Total $15 Total $15.0 Total $15 Total $15 Total $10 Total

$10 0

$10

Now, suppose that the company offers managers an option plan that is tax neutral from the finn's point of view. What will its terms be? The plan will need to have a present value of $2.5 million and will be constructed from a portfolio of 10 million at-the-money options granted to management. In return, management would have to agree to reduce its salary by $2.5 million-an equal dollar amount.

To handle the potential liability created by the plan, we assume that the finn creates a subsidiary that will have a balance sheet with $2.5 million in equity (the salary expense reduction) and will borrow $12.5 million via a zero-coupon bond with a face value of $15 million. The $15 million in cash is used to purchase 10 million shares of stock. Table 13.7 shows the current balance sheet of the subsidiary as well as its balance sheet in the good and bad states of nature. If the good state occurs, the options will be exercised, whereupon the subsidiary receives $15 million in cash and delivers stock worth $20 million. The $15 million in cash is used to pay off the loan and the equity in the subsidiary is worthless, leaving the parent firm with a $2.5 million tax-deductible loss. If the bad state occurs, the options will not be exercised, and the stock held by the subsidiary will be worth $10 million and turned over to the bank. The equity in the subsidiary will be worthless, once again leaving the parent with a tax-deductible loss. The bank lends $12.5 million, and its expected payoff is $12.5 million. The parent ends up with a $2.5 million loss either way.


Table 13.8 The Finn's Cash Flow, Given the SAR Plan (millions of dollars) Good State Bad State

Cash flow before salaries $140.0 $120.0 Salaries --97.5 -97.5

Cash flow after salaries 42.5 22.5 Investment loss -2.5 -2.5

Cash flow before taxes 40.0 20.0 Taxes -20.0 -10.0

Net cash flow $20.0 $l0.0

Table 13.8 shows the firm's expected cash flows given the terms of the option plan and its payouts from the subsidiary. Comparing the net cash flows of Tables 13.8 and 13.5, we see that the firm is completely indifferent between the two alternatives.1

From the management perspective, after-tax salary could be invested in stock options in order to have the same pattern of future risky payouts. The main advantage of the stock option plan is that taxes are deferred. Given that the plan is tax neutral from the firm s perspective and rax preferred by management, there is a strong incentive to use stock option plans.

Management, whose compensation is based on straight salary, cannot benefit from undertaking risky positive net present value projects unless their salaries are adjusted ex post to reflect good decisions. Stock option plans can help to correct this underinvestment problem because the options, and the stock, are immediately more valuable when risky positive net present value projects are initiated. There are several possible drawbacks, however. Management cannot easily diversify the greater firm-specific risk imposed by stock option plans and may require a higher level of expected compensation. From the shareholders' point of view, the cost of higher expected compensation may offset the benefit of reducing the underinvestment problem. Furthermore, stock options are not protected against dividend payments. This may change the behavior of management to have a bias against the payment of dividends and in favor of share repurchases. This may conflict with the wishes of some groups of shareholders and support the desires of others. Stock option plans may also bias management toward decisions that increase the variability of the stock price in an effort to increase the value of their stock options.

Studies of the announcement effect of the inception of stock option plans for management indicate that shareholders react favorably, considering the plan to be a net benefit Larker [1983] finds a significant positive residual on the day following receipt of the first shareholder proxy statement. Brickley, Bhagat, and Lease [1985] find a significant positive 2.4% cumulative return between the board of directors meeting and the Security and Exchange Commission stamp date for the proxy statement. Lemgruber [1986] used monthly return data for a sample of 119 firms with no other infonnation in their proxy statements except for the election of board members. For the interval between the board meeting and the release of the proxy statement, he found a significant 2.7% abnormal return.

I Note that we have not argued that the finn will use the tax shelter that has been created if it can write off the difference between the stock price and the exercise price in the good state of nature.


That the market reacts favorably to the inception of executive stock option plans is consistent with the benefits of the plan exceeding its costs from the shareholders' point of view. Call this the incentive hypothesis. It is also consistent with a signaling hypothesis. If managers have superior information concerning the future prospects of the firm, they would desire the implementation of a stock option plan when they believe the firm will do well. The market would respond favorably to their action. Positive announcement effects are also consistent with a tax hypothesis, namely, that the after-tax payoffs of a salary plus the stock option plan dominate those for a salary and bonus plan. Consequently, the value of the firm will rise following the inception of a stock option plan because total costs fall.

lt is not easy to separate the three aforementioned hypotheses. They are all consistent with the observation of positive abnormal returns at the inception of a stock option plan. They do, however, make different predictions regarding management behavior. For example, the incentive hypothesis predicts greater investment and higher leverage once the plan is started. The signaling and tax hypotheses predict greater earnings. All three hypotheses predict lower dividend payout. The empirical evidence seems to lend little support to the incentive hypothesis. For example, although Lemgruber [ 1986] found positive announcement returns, he found no significant changes in the rate of investment, in financial leverage, or in the variance of the stock price. Lambert and Larcker [19851 found that the variance decreased (a result that is inconsistent with Lemgruher). Lemgruber did, however, find significant decreases in dividend payout after the beginning of stock option plans. Tehrani an and Waegelein [ 1985] find that abnormal returns after the adoption of short-term compensation plans are associated with positive unexpected earnings. In sum, the empirical work suggests that stock option plans are adopted more for tax or signaling reasons than to reduce agency costs between owners and managers.

Although options are a tax-efficient way of delivering compensation to executives, and help to align the interests of owners and managers. a problem arises. namely. that a manager who has accumulated a sizeable amount of wealth in the form of options has an incentive to manipulate the market based on his inside information. If he can convince the market that he has received good news, the stock price will rise, thereby giving him the opportunity to exercise his options at a higher price. To mitigate this problem it is advisable to make the options exercisable only at certain points of time during the year. This separates the manager's ability to exercise the options from the freshness of inside information that he might have. Even better are "clawback" provisions that empower the board of directors to take back all gains from the exercise of stock options.

Very large stock option awards also become material for accounting reporting of earnings. FASB now requires that the present value of option plans be estimated and reported in a footnote. and that a fully diluted earnings estimate also be reported.

4. Total CEO Compensation Total CEO compensation has many separate components: salary, stock grants, stock options, pension and health benefits. perquisites, and the duration of the CEO's time in office. Additionally, there are contingent payment schemes such as evergreen contracts. golden parachutes, and golden handcuffs. Let's review the whole package.

Graef Crystal [1988] studied the top 100 of Fortune's 500 companies and found that CEO pay (including salary, bonus, the value of perquisites when available, and 20% of realized gains from long-term incentives, e.g., stock options) varies in line with a number of seemingly rational factors. See Table 13.9. The only problem is that shareholder returns is not one of them. The variables in his index of company performance (profits, return on equity, the market-to-book value of equity,


Table 13.9 Poor Alignment between CEO Pay and Shareholder Returns

Factor Definition/Comment Effect of a 10%

Increase on CEO Pay

Company size Index combining sales. assets. book equity. and number of employees

+2.QC/c

Company perforn1ance Index based on profits, 5-year average ROE. market-to-book value of equity, and 5-year average total return to investors

+31.0%

Company risk Government regulation Tenure of CEO Location

Beta Regulated companies pay less Longer tenure results in relatively lower pay More pay in high cost-of-living areas (e.g.,+ 7% for New York and I 0% for Los Angeles)

+5.0% NIA

-1.2% NIA

CEO age No effect on pay Shares owned by CEO No effect on pay

0.0% 0.0%

Note: CEO compensation includes salary. bonus, value of perquisites when available. and 20% of realized gains from Jong-term incentives (e.g., stock options). Source: Graef Crystal, Fortune. June 1988.

and the historic return to investors) are virtually uncorrelated with shareholder returns. Of course, he did not test to see whether changes in expectations regarding these variables had an impact mainly because he had no data on expectations.

Research by Jensen and Murphy [ 1990] studies the relationship between CEO bonus and salary compensation and various explanatory factors including the change in shareholder wealth. Table 13.10 shows the results. First, there is a statistically significant relationship between CEO compensation and firm-specific changes in shareholder wealth, even after accounting for the company performance relative to the industry (row 3) and relative to the economy (row 4). Second, the change in CEO compensation is incredibly small relative to what happens to the firm. For example, a $1,000 change in accounting profits results in a I 7. 7 cent increase in CEO pay (row 5, column 3). Overall, the results in Table 13.10 indicate that CEO compensatio11 is linked (but not very strongly) to changes in shareholder wealth, changes in accounting income, and changes in sales, but not to performance relative to the market or industry. Holding the effects of accounting profit and sales constant, a $1 ,000 increa,e in shareholder's wealth results in a. .74 cent increase in CEO compensation.

The relationship between the level of CEO compensation and the size of the company is much stronger, as shown in Table 13 .11. The r -squared is between 50 and 70%. The average elasticity is 30%. Thus, a CEO of a $200 million sales revenue company earns about 30% more than the CEO of a $100 million company.

Jensen and Murphy [1990] also estimate the total effects of all estimatable origins on CEO wealth. Note this is not salary and wage, but an estimate of the wealth of the CEO. Note that it includes the wealth effect of not being dismissed due to poor performance. Also, the relationship between pay and performance seems to be much larger for small firms than large. The largest single effect is changes in value of the company's stock with respect to stock ownership by the CEO, who had considerable skin in the game.


Table 13.10 Sensitivity of CEO Pay to Changes in Various Stock and Accounting-Related Measures of Performance( 1990 by The University of Chicago Press. Reprinted with permission.)

Regression Coefficients b Independent Variable a (1) (2) (3) (4) (5) Intercept 31.5 31.9 32.5 31.0 32.8 t,.(shareholder wealth) .0000140 .0000126 .0000074 .0000120 .0000074

(7.5) (4.8) (4.3) (7.1) (4.4) M wealth net-of-industry) c -.0000012

(-.7) M wealth net-of-market) c .0000013

(.4) t,.(accounting profits) .000177 .000187

(17.2) (15.7) t,.(sales) .0000122 -.0000034

(7.2) (-1.7) R2

.0083 .0082 .0449 .0148 .0453 Sample size 7,747 7,747 7.721 7,721 7,721

Note: The sample is constructed from longitudinal data reported in Forbes on 1,668 CEOs serving in 1,049 firms, 1974-1986; I-statistics are in parentheses. a. The variables are all measured in thousands of 1986 dollars. b. The dependent variable is '.(salary+ bonus), measured in thousands of 1986 constant dollars. The qualitative results are unchanged when '.(total pay) is used as the dependent variable. c. '.(wealth net-of-industry) is defined as (r, - i,)V,_ 1, where r, is shareholder return, V,_ 1 is beginning-of-period market value. and i1 is the value-weighted return for all other firms in the same two-digit industry. Similarly. '.(wealth net-of-market) is defined as (r, -m;)V,_ 1, where m, is the value-weighted return for all NYSE stocks. Source: Jensen and Murphy (1990).

Table 13.11 Estimated Elasticity of CEO Pay with Respect to Sales( 1990 by The University of Chicago Press. Reprinted with permission.)

Year

1973 1975 1979 1981 1983 R2

Manufacturing .313 .296 .297 .287 .285 .60 Retail trade .253 .271 .230 .306 .298 .53 Gas and electric utilities .331 .236 .347 .313 .314 .67 Commerical banking .337 .329 .367 .372 .404- .68 Insurance .313 .277 .299 .372 .345 .69

5. Set Stretch Targets In 1986 the board of directors of Ralston Purina announced that 491,000 shares of stock would be awarded to Ralston's top 14 executives (160,000 to the CEO) if the stock closed at or above $100 per share for 10 consecutive days any time within the next 10 years. The current stock price was $63. An increase from $63 to $100 represents a wealth gain of $811 million for shareholders, and the stock awarded to management would represent 6.05% of the gain in shareholder wealth. Is this

Figure 13-7 Cumula-tive abnormal perfor-mance of Ralston Purina. (Reprinted from Camp-bell and Wasley [ l 999]. with permission from Elsevier.)

1501 125 IOO

75 50 25


- Ralston return market adjusted --Ralston return minus peer group

O+IJ-,A!L_-~~~.-f..'.='lo&~~'..\-.1--l-.:!....\:

-25

an appropriate incentive for management? At first it seems so because both parties (management and shareholders) would gain-a win-win proposition.

Campbell and Wasley [ 1999] use the CAPM to estimate that had Ralston Purina mere! y earned its cost of equity, it would have taken four years and ten months to achieve the target share price. It actually took four years and five months. During the expected time to the award, Ralston's stock slightly underperformed the S&P 500 and greatly underperformed comparables. Figure 13. 7 shows the cumulative abnormal performance starting in June of 198 I, five years prior to the announcement of September 1986, and continuing beyond the time of the award in February 1991 up to June of 1992, which was the expected time of the award.

During the four years and five months that it took to earn the award, Ralston announced share repurchases seven times amounting to $1 .541 billion. Dividends plus share repurchases averaged 140% of net income between 1987 and 1990. As before, and once again, the moral of the story is that performance should be set relative to expectations. In this case management received a handsome reward for earning less than the cost of equity, for performance that fell below expectations. Stretch targets need to be set relative to expectations.

6. Incentive Design across Multiple Time Periods The multiperiod aspects of decison making are what make incentive design so difficult. Managers change jobs frequently, thereby creating the problem of giving proper attribution during the current compensation period for the effect of their decisions made years earlier in a different business unit Managers vary in the number of years before retirement, and this creates an end-game problem. Incentives based on the company's stock price may be less important for executives near the end of their career than those who are just starting. Also, one-year performance measures should be "guided" by a long-term view to avoid behavior that maximizes short-term performance at the expense of the long-run.

There is not much good theory to provide advice about a solution for this multi period problem. We offer two thoughts-creation of a "compensation bank" system, and control of share ownership based on expected time to retirement.

The compensation bank concept takes the awarded bonus received by an executive this year and puts it into a corporate trust ( or makes it a general obligation of the firm), where it vests to the


Table 13.12 An Example of a Compensation Bank Year1 Year2 Year3

Bonus award $500 $100 $300 Cash paid out a $100 $ 20 $ 60 Deposit to compensation bank $400 $ 80 $240 Amount in bank (end-of-year) $400 $520 $622 Less withdrawal b $ 0 $173 $207 Total cash compensation $100 $193 $267 Bank balance forward c $400 $347 $415 a. 20% bonus b. 33.3% of balance c. Earns 10% interest

executive over a period of time. Vesting may be granted by a review board or be automatic over time. Table 13. I 2 provides a short example.

7. Designing Incentives for Different Layers of Management The incentive structure that is appropriate for top management is quite different than that of successively lower layers of management. Top management can directly impact the share price of the company. Business unit leadership cannot, nor can sub-business unit, project, or plant management. Everyone, of course, will be happy to accept a stock option plan if the grants are supplementary to their existing level of compensation, but when faced with the more difficult choice of whether they want to give up an amount of existing income in order to receive an equivalent value of stock options, few employees decide to switch. The most important reason is that further down in the organization, managers have little or no direct influence on the company's stock price. They would. rather have their bonus compensation tied to something that they control and where they have a reasonable chance of exceeding expectations. A second reason is that they cannot separate the value of their human capital from the value of the company; therefore stock options do not allow them to diversify, whereas a cash bonus for superior performance on their value drivers can be reinvested elsewhere, thereby allowing diversification.

Middle management usually receives a salary plus bonus. The problem with most bonus systems is that they do not require forced ranking, and consequently everyone is placed in the top two or three categories. A study by Medoff and Abraham [ I 980] surveyed two large companies and found that the first, with 4, 788 employees, placed 94.5% in the top two of four ratings. The second company rated 2,841 managers into six categories and 98.8% fell into the highest three ratings. Further analysis indicated that earnings differentials between jobs were much more significant than earnings differentials (i.e., bonus differences) within job categories. In other words, promotion is much more important as a differentiator than are bonuses. Murphy [1985] found that for a sample of vice presidents of large companies, promotion implied an average 18.8% pay increase while the average pay increase given no promotion was only 3.3%. There are two implications. First, bonus systems can be more effective signals if rank ordering is required. But since the more meaningful


economic signal is promotion, it is wise to place a great deal of effort in doing the evaluation well.

Lower-level management incentive pay, called gain sharing, actually results in productivity gains. Mitchell, Lewin, and Lawler [ 1990] study the relationship between the hourly wages earned (the dependent variable in a multiple regression) and two independent variables, the proportion of workers with incentives and the existence of an incentive plan. Based on 716 companies they obtained a cross-sectional r-squared of 68%, and both independent variables were highly significant. The concept of linking the performance of employees to value drivers under their control actually works quite well.

8. The Issue of Relative Performance-Who Is Responsible? Arguably, one drawback of incentive plans tied to changes in the stock price is that not all stock price movements are attributable to management decisions. Why should management be responsible for a change in the market rate of interest as driven by the Federal Reserve Bank? One point of view would argue that senior management should, in fact be held responsible for the total movement in stock prices. It is possible to hedge. For example, a gold mine can be thought of as a portfolio of risky assets that is long in gold and other precious metals. An offsetting position can be created by shorting futures on gold. The net effect would be to reduce the mining company's exposure to fluctuations in the price of gold-and were the hedge perfect, the equity of the gold mining company could theoretically be turned into a low-risk or even risk-free bond. In a sense, if management decides to be in the gold business, it is making a conscious decision to do so on behalf of shareholders. There is no risk that cannot be managed in the long run-if not by hedging or diversifying, then by simply deciding to get out of the business. Therefore, there is a strong philosophical point of view that favors total management responsibility for any movement in the stock price, whatever the cause. The maxim is simple. Maximize shpreholder wealth.

An alternative point of view argues that management of a gold mine should have a comparative advantage in operating gold mines and in finding and developing new sources of gold. Manage-ment should not be expected to also specialize in hedging. Therefore, if the stock price of the gold mining company changes because interest rates rise or because the economy goes into a recession, management should be indemnified. One of the implications, of course, is that if man-agement is compensated on its relative (not on its absolute) performance, then it may receive high compensation in a depressed economy or low compensation in a buoyant economy.

To some extent it is possible to measure the performance of a company after removing the effect of exogenous factors that are judged to be beyond the control of management. We show, in Chapter 14, the details of how to build a spreadsheet discounted cash flow model of a company. It is based on assumptions made by analysts concerning value drivers such as the nominal rate of growth in revenues, operating margins, capital turns, and the cost of capital. This type of model typically produces a valuation that is 85% ( or higher) correlated with the actual market price. Given this degree of accuracy, the DCF model can then be manipulated to show the separate effects of exogenous variables on the stock from management performance relative to expectations. While still more an art than a science, nevertheless, this process is one way of infonning the judgment of the decision makers who arbitrate the level of total compensation for relative perfonnance. In this way, if so desired, it is possible to remove the effect of a change in the price of gold from the actual change in the stock price of a gold mine.

494 Chapter13: The Role of the CFO, Performance Measurement, and Incentive Design

We started this chapter with the role of the chief financial officer-a role that has increased in complexity with the emergence of multibusiness, multinational companies. Years ago the CFO was an accountant, but today he or she is one of the top decision makers in the company and often is elevated to the role of CEO. The CFO's responsibilities are broad, including managerial decisions such as performance measurement, incentive design, public relations, and the management of human resources. Financial decisions include risk management, capital structure and the cost of capital, dividend policy, tax policy, and working capital management. The CFO is also usually responsible for major investment decisions including research and development spending, large internal projects, and mergers and acquisitions.

The CFO is confronted with the problem of choosing a measure of performance that is highly correlated with the change in shareholders' wealth. We saw that for one-year time intervals the best measure was the difference between actual and expected economic profit, the keystone for expectations-based management. Closely related is a multiperiod measure, namely, discounted cash.flow valuation. In the next chapter we shall prove that the sum of discounted economic profits, when added to the book value of assets, equals the discounted cash flow value of the company.

Given that expectations drive the share price of companies, we then discussed the myriad of thorny problems concerning the design of incentive programs-what the agency problems are, how they are usually handled, and the realization that there is no perfect solution.

PROBLEM SET 13.1 Prove the following theorem: "The present value of forecasted economic profit. when dis-counted at the weighted average cost of capital, plus the book value of assets, equals the DCF value of the firm." 13.2 Suppose that a firm has a project that was started last year, and it is expected to earn less than its cost of capital if left unchanged. Management comes up with these suggestions .

. (a) Invest in a debottlenecking project that will raise economic profit, but not up to the cost of capital. (b) Cut operating costs but not enough to earn the cost of capital. (c) Sell the unprofitable business unit for a premium over its book value.

Some numbers are given in Table Q13.2. Value each alternative and compare them in terms of value creation. 13.3 Some companies measure performance by requiring both "top line" growth and "bottom line" growth (i.e., growth in revenues and growth in net income). Is this perfon11ance measure consistent with shareholder value creation? Why or why not? 13.4 Why are EPS, the percent change in EPS, EVA, and the change in EVA unrelated to TRS (total return to shareholders) in Table 13.2? 13.5 Management has informed the market that it expects to earn 30% on project A and 40% on project B, and these expectations are already baked into the firm's current stock price. The cost of capital for both projects is 10%. The amount of investment required for project A is $5 million, and project B requires $30 million. Just before it is about to invest in project B, the company learns that the expected rate on the project will be 30%, not 40%.

References 495

Table Q13.2 Data for Q 13.2 Base Case (a) Debottleneck (b) Cut Costs (c) Sell for 10% Premium

WACC I 0


Miller, M., and M. Scholes, "Dividends and Taxes: Some Empirical Evidence," Journal of Political Economy, December 1982, 1118-1141.

Mitchell, D., F. Lewin, and D. Lawler, "Alternative Pay Systems, Firm Performance and Productivity;' in A. Blinder, ed., Paying for Productivity, 1990, Brookings Institution.

Murphy, K., "Corporate Performance and Managerial Remuneration," Journal of Accounting and Economics, April 1985, 11-42.

Smith, C., and R. Watts, "Incentive and Tax Effects of Executive Compensation Plans," Australian Journal of Management, 1982, Vol. 7, No. 2, 139-157.

Tehranian, H., andJ. Waegelein, "Market Reaction to Short-Term Executive Compensation Plan Adoption," Journal of Accounting and Economics, April 1985, 131-144.

financial theory and corporate policy cap 13

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