Chapter 13 Principles PrinciplesofCorporateFinance 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

13- 2 Topics Covered  Incentives and Compensation  Measuring and Rewarding Performance: Residual Income and EVA  Bias in Accounting Measures of Performance

13- 3 The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

13- 4 Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

13- 5 Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

13- 6 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.

13- 7 CEO Compensation (2005) Thousands of Dollars

13- 8 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.

13- 9 Residual Income & EVA Income Sales 550 COGS 275 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)

Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

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.

Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10% © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

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

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

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? 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.

EVA of US firms ($ in millions)

Accounting Measurements Economic income = cash flow + change in present value

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

Nodhead Book Income & ROI

Nodhead Store Forecasts

Nodhead Peer Book ROI

Nodhead Growth v. Return Rate of Return (%) Rate of Growth (%) Economic rate of return Book rate of return

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