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Chapter 13
Agency Problems, Management Compensation, and The Measurement of Performance

Main Topics of Chapter

Incentives
Making sure that managers and employees are rewarded appropriately when they add value to the firm

Performance Measurement
Performance should be rewarded so how should performance be measured?

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Decisions
Top Management (and investors) want managers to invest in + NPV projects. Why cant top management make all investment decisions?
Too many projects to analyze Investment decisions top mgmt might not see Investments not in capital budget
i.e. R&D

Agency Problems
What is top management was on fixed salary?
Reduced effort Perks Empire building
Prefer large to small

Entrenchment investment
Choose projects that reward skills of exiting mgmt

Small decisions add up

Avoiding risk
Why not, no upside potential

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Monitoring
Agency costs can be reduced by monitoring.
BUT, monitoring requires time and $

Management Compensation
Management Compensation
How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

Who monitors?
Ultimately it is the shareholders responsibility.
Shareholders can elect a board of directors Lenders can monitor Monitoring can be difficult for individual shareholders
Free rider problem (owners rely on the efforts of others to monitor the company)

Because monitoring is imperfect, compensation plans must give correct incentives.

Effort is not observable, compensation should be based on output (results), not effort. Mgmt should be rewarded when firm does well, and not when it does not.
Risk should be considered (i.e. cyclical businesses)

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Stock Option Plans

Options are used for incentives
Thousands of Dollars
$2,500

CEO Compensation (2005)

Accounting rule change in 2006 options have to be valued more reasonably for shareholders

$2,000

At least 3 imperfections
They reward absolute rather than relative performance Returns depend on how company performs relative to expectations Tend to have mgmt smooth earnings
They make sure not to depress earnings in short run

$1,500

$1,000

Long-term incentives & variable bonus Basic compensation, benefits, & perks

$500

$0

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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.
Sales COGS

Residual Income & EVA

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

Selling, G&A

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Residual Income & EVA

Quayle City Subduction Plant ($mil)

Residual Income & EVA

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

ROI

130 .13 1,000

Given COC = 10%

EVA Residual Income Income Earned - income required Income Earned - Cost of Capital Investment

NetROI 13% 10% 3%

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Residual Income & EVA

Quayle City Subduction Plant ($mil)

Economic Profit
Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

Given COC = 10%

EVA Residual Income 130 (.10 1,000) $30 million

EP Economic Profit ( ROI r ) Capital Invested

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Economic Profit
Quayle City Subduction Plant ($mil)
Example at 10% COC continued.

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

EP ( ROI r ) Capital Invested (.13 - .10) 1,000 $30 million

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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?

EVA of US firms 2005 (table 13.2, page 336).

($ in millions)

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Econimic Value Added (EVA) Microsoft Johnson & Johnson Wal-Mart Stores Merck Coca-Cola Intel Corp Dow Chemical Boeing IBM Delta Airlines Pfizer Time Warner Lucent Technologies 8,247 6,601 5,199 3,765 3,637 3,264 1,749 (67) (196) (1,413) (3,838) (5,153) (6,279)

Capital Invested 28,159 60,857 109,393 32,400 18,353 34,513 44,281 41,813 71,196 25,639 209,293 132,985 61,987

Return on Capital 40.9 19.0 10.8 18.4 25.3 23.2 10.2 5.6 10.5 1.0 5.8 3.8 (0.7)

Cost of Capital 11.7 7.8 5.8 7.6 5.9 13.2 6.3 5.8 10.8 6.3 7.6 7.8 9.6

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.