1. Chapter 12 Principles of Corporate Finance Eighth Edition Agency Problems, Management Compensation, and The Measurement of Performance Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 2 McGraw-Hill/Irwin Topics Covered  The Capital Investment Process  Decision Makers Need Good Information  Incentives  Residual Income and EVA  Bias in Accounting Measures of Performance  Measuring Economic Profitability

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 3 McGraw-Hill/Irwin The Principal Agent Problem Shareholders = Owners Managers = Employees Question: Who has the power? Answer: Managers

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 4 McGraw-Hill/Irwin Capital Investment Decision Project Creation “Bottom Up” Strategic Planning “Top Down” Capital Investments

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 5 McGraw-Hill/Irwin Capital Investment Process  Capital budget  Project authorization  R&D  Marketing  Post-audits

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 6 McGraw-Hill/Irwin Off Budget Expenditures  Information Technology  Research and Development  Marketing  Training and Development

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 7 McGraw-Hill/Irwin Information Problems 1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest The correct information is …

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 8 McGraw-Hill/Irwin Brealey, Myers & Allen’s Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 9 McGraw-Hill/Irwin Incentives  Reduced effort  Perks  Empire building  Entrenching investment  Avoiding risk Agency Problems in Capital Budgeting

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 10 McGraw-Hill/Irwin 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.

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 11 McGraw-Hill/Irwin CEO Compensation (2003-04)

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 12 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 13 McGraw-Hill/Irwin 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)

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 14 McGraw-Hill/Irwin Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 15 McGraw-Hill/Irwin 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.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 16 McGraw-Hill/Irwin Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 10%

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 17 McGraw-Hill/Irwin 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.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 18 McGraw-Hill/Irwin Economic Profit © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission. Quayle City Subduction Plant ($mil) Example at 10% COC continued.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 19 McGraw-Hill/Irwin 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

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 20 McGraw-Hill/Irwin EVA of US firms - 2003 ($ in millions)

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 21 McGraw-Hill/Irwin Accounting Measurements Economic income = cash flow + change in present value

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 22 McGraw-Hill/Irwin 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

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 23 McGraw-Hill/Irwin Nodhead Book Income & ROI

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 24 McGraw-Hill/Irwin Elements of a Desirable Monitoring System  Long Run View:  Can distinguish between desirable and undesirable decisions  Reflects what is happening to the stockholders’ wealth  Takes into account scarce capital allocations  Takes into account the opportunity cost of capital How does EVA and ROI do with respect to these?

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 25 McGraw-Hill/Irwin Nodhead Store Forecasts Economic Profitability

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 26 McGraw-Hill/Irwin Elements of a Desirable Monitoring System  Long Run View:  Can distinguish between desirable and undesirable decisions  Reflects what is happening to the stockholders’ wealth  Takes into account scarce capital allocations  Takes into account the opportunity cost of capital How does Economic Profitability and Rate of Return do on these dimensions?

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 12- 27 McGraw-Hill/Irwin Web Resources www.sternstewart.com www.emblemsvag.com/economic_profit.htm Click to access web sites Internet connection required