lec 9 agency problem
TRANSCRIPT
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Chapter 13Principles
of
CorporateFinance
Ninth Edition
Agency Problems,Management Compensation,
and The Measurement of
Performance
Slides by
Matthew Will
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
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Topics Covered
Incentives and CompensationMeasuring and Rewarding Performance:
Residual Income and EVA
Bias in Accounting Measures ofPerformance
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The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who has
the power?
Answer: Managers
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Information Problems
1. Consistent Forecasts2. Reducing Forecast Bias
3. Getting Senior Management
Needed Information4. Eliminating Conflicts of
InterestThe correct
information
is …
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Incentives
Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
Agency Problems in Capital Budgeting
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Incentive Issues
Monitoring - Reviewing the actions of managersand 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 paymanagers so as to reduce the cost and need for
monitoring and to maximize shareholder value.
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CEO Compensation (2005)
$0
$500
$1,000
$1,500
$2,000
$2,500
Long-term incentives & variable bonus
Basic compensation, benefits, & perks
T h o u s a n d s o f D o l l a r s
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Residual Income & EVA
Techniques for overcoming errors in accountingmeasurements of performance.
Emphasizes NPV concepts in performance
evaluation over accounting standards.
Looks more to long term than short termdecisions.
More closely tracks shareholder value thanaccounting measurements.
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Residual Income & EVA
Income
Sales 550
COGS 275
Selling, G&A 75
200
taxes @ 35% 70
Net Income $130
Assets
Net W.C. 80
Property, plant and
equipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle City Subduction Plant ($mil )
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Residual Income & EVA
Quayle City Subduction Plant ($mil )
13.
000,1
130 ROI
Given COC = 10%
%3%10%13 NetROI
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Residual Income & EVA
InvestmentCapitalof Cost-EarnedIncome
requiredincome-EarnedIncome
IncomeResidual
EVA
Residual I ncome or EVA = Net Dollar returnafter deducting the cost of capital
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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Residual Income & EVA
million03$
)000,110(.130
IncomeResidual
EVA
Quayle City Subduction Plant ($mil )
Given COC = 10%
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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Economic Profit
InvestedCapital)(
ProfitEconomic
r ROI
EP
Economic Prof i t = capital investedmultiplied by the spread between return on
investment and the cost of capital.
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Economic Profit
million$30
1,000.10)-.13(
InvestedCapital)(
r ROI EP
Quayle City Subduction Plant ($mil )
Example at 10% COC continued.
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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 $100 million. Given a 10% cost of
capital, what is the EVA of the project and was it a good investment?
million02$
)10010(.30
EVA
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.
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EVA of US firms - 2005
Econimic Value Added
(EVA)
Capital
Invested
Return on
Capital
Cost of
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
($ in millions)
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Accounting Measurements
0
011 )(
price beginning priceinchangereceiptscashreturnof Rate
P
P P C
Economic income = cash flow + change in present value
0
011 )(returnof Rate
PV
PV PV C
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Accounting Measurements
ECONOMIC ACCOUNTING
Cash flow + Cash flow +
change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation
Economic income Accounting income
PV at start of year BV at start of year
INCOME
RETURN
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Nodhead Book Income & ROI
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
Year
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Nodhead Store Forecasts
1 2 3 4 5 6
Cash flow 100 200 250 298 298 297
PV, at start of year, 10 percentdiscount 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
Year
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Nodhead Peer Book ROI
1 2 3 4 5 6
Book Income forstore
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 -67Total 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
Year
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Nodhead Growth v. Return
Rate of Return(%)
Rate of Growth
(%)
Economic rate of return
Book rate of return
12
11
10
9
8
7
5 10 15 20 25
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Web Resources
www.sternstewart.com
http://www.emblemsvag.com/economic_profit.htm
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