Making Sure Managers Maximize NPV Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 12 McGraw Hill/Irwin

12- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  The capital investment process  Decision Makers and Information  Incentives  Residual Income and EVA  Accounting Performance Measures  Economic Profit

12- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

12- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Capital Investment Decision Project Creation “Bottom Up” Strategic Planning “Top Down” Capital Investments

12- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Off Budget Expenditures  Information Technology  Research and Development  Marketing  Training and Development

12- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

12- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Growth and Returns Rate of return, % Rate of growth, % Economic rate of return Book rate of return

12- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Brealey & Myers Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.

12- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.  Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Residual Income & EVA Income Sales550 COGS275 Selling, G&A % 70 Net Income$130 Assets Net W.C. 80 Property, plant and equipment1170 less depr.360 Net Invest..810 Other assets110 Total Assets$1,000 Quayle City Subduction Plant ($mil)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 12%

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Economic Profit © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission. Quayle City Subduction Plant ($mil) Example at 12% COC continued.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved EVA of US firms $ in millions)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Accounting Measurements

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Accounting Measurements Economic income = cash flow + change in present value

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Accounting Measurements ECONOMICACCOUNTING Cash flow +Cash flow + change in PV =change in book value =Cash flow - economic depreciationaccounting depreciation Economic incomeAccounting income PV at start of yearBV at start of year INCOME RETURN

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Nodhead Store Forecastes

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Nodhead Book Income & ROI

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 13, P