Lec 9 Agency Problem

8/13/2019 Lec 9 Agency Problem

http://slidepdf.com/reader/full/lec-9-agency-problem 1/24

Chapter 13Principles

of

CorporateFinance

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



Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

13- 2

McGraw Hill/Irwin

Topics Covered

Incentives and CompensationMeasuring and Rewarding Performance:

Residual Income and EVA

Bias in Accounting Measures ofPerformance




13- 3

McGraw Hill/Irwin

The Principal Agent Problem

Shareholders = Owners

Managers = Employees

Question: Who has

the power?

Answer: Managers




13- 4

McGraw Hill/Irwin

Information Problems

1. Consistent Forecasts2. Reducing Forecast Bias

3. Getting Senior Management

Needed Information4. Eliminating Conflicts of

InterestThe correct

information

is …




13- 5

McGraw Hill/Irwin

Incentives

Reduced effort

Perks

Empire building

Entrenching investment

Avoiding risk

Agency Problems in Capital Budgeting




13- 6

McGraw Hill/Irwin

Incentive Issues

Monitoring - Reviewing the actions of managersand 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 paymanagers so as to reduce the cost and need for

monitoring and to maximize shareholder value.


http://slidepdf.com/reader/full/lec-9-agency-problem 7/24Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

13- 7

McGraw Hill/Irwin

CEO Compensation (2005)

$0

$500

$1,000

$1,500

$2,000

$2,500

Long-term incentives & variable bonus

Basic compensation, benefits, & perks

T h o u s a n d s o f D o l l a r s



13- 8

McGraw Hill/Irwin

Residual Income & EVA

Techniques for overcoming errors in accountingmeasurements of performance.

Emphasizes NPV concepts in performance

evaluation over accounting standards.

Looks more to long term than short termdecisions.

More closely tracks shareholder value thanaccounting measurements.



13- 9

McGraw Hill/Irwin


Income

Sales 550

COGS 275

Selling, G&A 75

200

taxes @ 35% 70

Net Income $130

Assets

Net W.C. 80

Property, plant and

equipment 1170

less depr. 360

Net Invest.. 810

Other assets 110

Total Assets $1,000

Quayle City Subduction Plant ($mil )



13- 10

McGraw Hill/Irwin



13.

000,1

130 ROI

Given COC = 10%

%3%10%13 NetROI



13- 11

McGraw Hill/Irwin


InvestmentCapitalof Cost-EarnedIncome

requiredincome-EarnedIncome

IncomeResidual

EVA

Residual I ncome or EVA = Net Dollar returnafter deducting the cost of capital

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.



13- 12

McGraw Hill/Irwin


million03$

)000,110(.130

IncomeResidual

EVA


Given COC = 10%

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.



13- 13

McGraw Hill/Irwin

Economic Profit

InvestedCapital)(

ProfitEconomic

r ROI

EP

Economic Prof i t = capital investedmultiplied by the spread between return on

investment and the cost of capital.



13- 14

McGraw Hill/Irwin

Economic Profit

million$30

1,000.10)-.13(

InvestedCapital)(

r ROI EP


Example at 10% COC continued.





13- 16

McGraw Hill/Irwin

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?

million02$

)10010(.30

EVA

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.



13- 17

McGraw Hill/Irwin

EVA of US firms - 2005

Econimic Value Added

(EVA)

Capital

Invested

Return on

Capital

Cost of

Capital

Microsoft 8,247 28,159 40.9 11.7

Johnson & Johnson 6,601 60,857 19.0 7.8

Wal-Mart Stores 5,199 109,393 10.8 5.8

Merck 3,765 32,400 18.4 7.6

Coca-Cola 3,637 18,353 25.3 5.9

Intel Corp 3,264 34,513 23.2 13.2

Dow Chemical 1,749 44,281 10.2 6.3

Boeing (67) 41,813 5.6 5.8

IBM (196) 71,196 10.5 10.8

Delta Airlines (1,413) 25,639 1.0 6.3

Pfizer (3,838) 209,293 5.8 7.6 Time Warner (5,153) 132,985 3.8 7.8

Lucent Technologies (6,279) 61,987 (0.7) 9.6

($ in millions)



13- 18

McGraw Hill/Irwin

Accounting Measurements

0

011 )(

price beginning priceinchangereceiptscashreturnof Rate

P

P P C

Economic income = cash flow + change in present value

0

011 )(returnof Rate

PV

PV PV C



13- 19

McGraw Hill/Irwin

Accounting Measurements

ECONOMIC ACCOUNTING

Cash flow + Cash flow +

change in PV = change in book value =

Cash flow - Cash flow -

economic depreciation accounting depreciation

Economic income Accounting income

PV at start of year BV at start of year

INCOME

RETURN

13 20



13- 20

McGraw Hill/Irwin

Nodhead Book Income & ROI

1 2 3 4 5 6

Cash flow 100 200 250 298 298 297

Book value at start of year,

straight-line depreciation 1000 834 667 500 333 167

Book value at end of year,

straight-line depreciation 834 667 500 333 167 0

Book depreciation 167 167 167 167 167 167

Book income -67 33 83 131 131 130

Book ROI -0.067 0.04 0.125 0.263 0.394 0.782

Forecasted EVA (5-.1 *2) -167 -50 17 81 98 114

Year

13 21




13- 21

McGraw Hill/Irwin

Nodhead Store Forecasts

1 2 3 4 5 6

Cash flow 100 200 250 298 298 297

PV, at start of year, 10 percentdiscount rate 1000 1000 900 740 516 270

PV, at end of year, 10 percent

discount rate 1000 900 740 516 270 0

Economic depreciation 0 100 160 224 246 270

Economic income 100 100 90 74 52 27

Rate of return 0.1 0.1 0.1 0.1 0.1 0.1

Forecasted EVA (5-.1*2) 0 0 0 0 0 0

Year

13 22




13- 22

McGraw Hill/Irwin

Nodhead Peer Book ROI

1 2 3 4 5 6

Book Income forstore

1 -67 33 83 131 131 130

2 -67 33 83 131 131

3 -67 33 83 131

4 -67 33 83

5 -67 33

6 -67Total book income -67 -33 50 181 312 443

Book value for store

1 1000 834 667 500 333 167

2 1000 834 667 500 333

3 1000 834 667 500

4 1000 834 667

5 1000 834

6 1000

Total book value 1000 1834 2501 3001 3334 3501

Book ROI for all

stores -0.067 -0.018 0.02 0.06 0.094 0.126

EVA for all stores -166.73 -216.79 -200.19 -118.91 -20.96 92.66

Year

13 23




13- 23

McGraw Hill/Irwin

Nodhead Growth v. Return

Rate of Return(%)

Rate of Growth

(%)

Economic rate of return

Book rate of return

12

11

10

9

8

7

5 10 15 20 25

13 24



13- 24

Web Resources

www.sternstewart.com

http://www.emblemsvag.com/economic_profit.htm

Click to access web sites

Internet connection required

http://www.sternstewart.com/



http://www.sternstewart.com/

Documents

Lec 9 Agency Problem