Advanced Corporate Finance FINA 7330 Ronald F. Singer Agency Problems and Control Lecture 4 Fall, 2010

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

Conflicts of Interest Reduced effort on the part of the agent Excessive perks consumption Empire building Entrenchment Risk avoidance

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

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

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

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

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.

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.

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

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 value Rewards quick paybacks and ignores time value of money

What is Economic Value Added (EVA) EVA = Residual Income = Income earned – Income required = Income earned – Cost of Capital X Capital Invested Note: 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)

EVA of US firms ($ in millions)

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