1Chapter 13Agency Problems, Management Compensation, and The Measurement of Performance13- 2Main Topics of ChapterIncentives– Making sure that managers and employees are rewarded appropriately when they add value to the firmPerformance Measurement– Performance should be rewarded – so how should performance be measured?13- 3DecisionsTop Management (and investors) want managers to invest in + NPV projects. Why can’t top management make all investment decisions?– Too many projects to analyze– Investment decisions top mgmt might not see– Investments not in capital budget• i.e. R&D– Small decisions add up13- 4Agency ProblemsWhat is top management was on fixed salary?– Reduced effort– Perks– Empire building• Prefer large to small– Entrenchment investment• Choose projects that reward skills of exiting mgmt– Avoiding risk• Why not, no upside potential13- 5MonitoringAgency costs can be reduced by monitoring.– BUT, monitoring requires time and $Who monitors?– Ultimately it is the shareholders responsibility.• Shareholders can elect a board of directors• Lenders can monitor• Monitoring can be difficult for individual shareholders– Free rider problem (owners rely on the efforts of others to monitor the company)13- 6Management CompensationManagement Compensation– How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.Because monitoring is imperfect, compensation plans must give correct incentives.– Effort is not observable, compensation should be based on output (results), not effort.– Mgmt should be rewarded when firm does well, and not when it does not.• Risk should be considered (i.e. cyclical businesses)213- 7Stock Option PlansOptions are used for incentives– Accounting rule change in 2006 – options have to be valued more reasonably for shareholdersAt least 3 imperfections– They reward absolute rather than relative performance– Returns depend on how company performs relative to expectations– Tend to have mgmt smooth earnings• They make sure not to depress earnings in short run13- 8CEO Compensation (2005)$0$500$1,000$1,500$2,000$2,500Long-term incentives & variable bonusBasic compensation, benefits, & perksThousands of Dollars13- 9Residual 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- 10Residual Income & EVAIncomeSales 550COGS 275Selling, G&A 75200taxes @ 35% 70Net Income $130AssetsNet W.C. 80Property, plant andequipment 1170less depr. 360Net Invest.. 810Other assets 110Total Assets $1,000Quayle City Subduction Plant ($mil)13- 11Residual Income & EVAQuayle City Subduction Plant ($mil)13.000,1130ROIGiven COC = 10%%3%10%13 NetROI13- 12Residual Income & EVA Investment Capital ofCost - Earned Incomerequired income-Earned Income Income ResidualEVAResidual Income or EVA = Net Dollar return after deducting the cost of capital313- 13Residual Income & EVAmillion 03$)000,110(.130 Income ResidualEVAQuayle City Subduction Plant ($mil)Given COC = 10%13- 14Economic ProfitInvested Capital)( Profit EconomicrROIEPEconomic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.13- 15Economic Profitmillion $301,000.10)-.13(Invested Capital)( rROIEPQuayle City Subduction Plant ($mil)Example at 10% COC continued.13- 16Message 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 money13- 17EVA LessonExample – 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 $100 million. Given a 10% cost of capital, what is the EVA of the project and was it a good investment?million 02$)10010(.30EVAAnswer - 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- 18EVA of US firms – 2005 (table 13.2, page 336).Econimic Value Added (EVA)Capital InvestedReturn on CapitalCost of CapitalMicrosoft 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