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Making Sure Managers Maximize NPV Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 12 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 2 Topics Covered The capital investment process Decision Makers and Information Incentives Residual Income and EVA Accounting Performance Measures Economic Profit
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 3 The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 4 Capital Investment Decision Project Creation “Bottom Up” Strategic Planning “Top Down” Capital Investments
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 5 Off Budget Expenditures Information Technology Research and Development Marketing Training and Development
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 6 Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 7 Growth and Returns 12 11 10 9 8 7 510152025 Rate of return, % Rate of growth, % Economic rate of return Book rate of return
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 8 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.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 9 Incentives Reduced effort Perks Empire building Entrenching investment Avoiding risk Agency Problems in Capital Budgeting
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 10 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.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 11 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.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 12 Residual Income & EVA Income Sales550 COGS275 Selling, G&A 75 200 taxes @ 35% 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)
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 13 Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 14 Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital. © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 15 Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 12%
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 16 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.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 17 Economic Profit © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission. Quayle City Subduction Plant ($mil) Example at 12% COC continued.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 18 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.
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 19 EVA of US firms - 1997 $ in millions)
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 20 Accounting Measurements
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 21 Accounting Measurements Economic income = cash flow + change in present value
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 22 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
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 23 Nodhead Store Forecastes
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© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 12- 24 Nodhead Book Income & ROI
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