Principles of

Corporate Finance
Chapter 12 Eighth Edition

Agency Problems,
Management
Compensation, and
The Measurement
Slides by
of Performance Matthew Will

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 12- 2

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

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 12- 3

The Principal Agent Problem

Question: Who has

Shareholders = Owners the power?

Answer: Managers
Managers = Employees

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 12- 4

Capital Investment Decision

Strategic Planning
“Top Down”

Capital Investments

Project Creation
“Bottom Up”

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 12- 5

Capital Investment Process

 Capital budget
 Project authorization
 R&D
 Marketing
 Post-audits

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Off Budget Expenditures

Information Technology
Research and Development
Marketing
Training and Development

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

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 12- 8

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.

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 12- 9

Incentives

Agency Problems in Capital Budgeting

 Reduced effort
 Perks
 Empire building
 Entrenching investment
 Avoiding risk

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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.

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 12- 11

CEO Compensation (2003-04)

00
25 Benefits
Perks
Options & Others
000 Variable Bonus
2
Basic Compensation
$ 1,000 s

00
15

000
1

0
50

United Kingdom
India
Australia

China

Spain

Switzerland
Germany

Singapore
Netherlands
Japan
Canada

Italy

0
Fance

Mexico

United States
Sweden

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 12- 12

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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 12- 13

Residual Income & EVA

Quayle City Subduction Plant ($mil)
Income Assets
Sales 550 Net W.C. 80
COGS 275 Property, plant and
equipment 1170
Selling, G&A 75
less depr. 360
200
Net Invest.. 810
taxes @ 35% 70
Other assets 110
Net Income $130
Total Assets $1,000

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 12- 14

Residual Income & EVA

Quayle City Subduction Plant ($mil)

130
ROI   .13
1,000

Given COC = 10%

NetROI  13%  10%  3%

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Residual Income & EVA

Residual Income or EVA = Net Dollar return
after deducting the cost of capital

EVA  Residual Income

 Income Earned - income required
 Income Earned -  Cost of Capital  Investment

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

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 12- 16

Residual Income & EVA

Quayle City Subduction Plant ($mil)

Given COC = 10%

EVA  Residual Income

 130  (.10  1,000)
 $30 million

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 12- 17

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

EP  Economic Profit
 ( ROI  r )  Capital Invested

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

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 12- 18

Economic Profit
Quayle City Subduction Plant ($mil)

Example at 10% COC continued.

EP  ( ROI  r )  Capital Invested

 (.13 - .10)  1,000
 $30 million

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

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 12- 19

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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 12- 20

EVA of US firms - 2003

($ in millions)

Econimic Value Added Capital Return on Cost of

(EVA) Invested Capital Capital
Wal-Mart Stores 4,525 79,177 12.30% 6.60%
Johnson & Johnson 4,459 51,508 17.6 8.9
Microsoft 4,027 24,677 29.8 13.5
Merck 3,347 40,941 16.9 8.7
Coca Cola 2,729 20,503 20.1 6.7
Intel Corp. (57) 31,216 15.6 15.8
Dow Chemical (1,503) 44,158 3.6 7
Boeing (1,974) 50,046 2.2 6.1
Delta Airlines (2,288) 27,238 -0.9 7.5
Viacom (5,508) 96,515 3.5 9.2
IBM (7,505) 108,926 4.6 11.5

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 12- 21

Accounting Measurements
cash receipts  change in price
Rate of return 
beginning price
C1  ( P1  P0 )

P0

Economic income = cash flow + change in present value

C1  ( PV1  PV0 )
Rate of return 
PV0

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 12- 22

Accounting Measurements

ECONOMIC ACCOUNTING
INCOME Cash flow + Cash flow +
change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation
RETURN
Economic income Accounting income
PV at start of year BV at start of year

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 12- 23

Nodhead Book Income & ROI

Year
1 2 3 4 5 6
Cash flow 100 200 250 298 298 298
Book value at start of year,
straight-line depreciation 1000 833 667 500 333 167
Book value at end of year,
straight-line depreciation
Book depreciation 167 167 167 167 167
Book income -67 33 83 131 131
Book ROI -0.67 0.04 0.124 0.262 0.393 0.784
Forecasted EVA (5-.1 *2) -167 -50 17 81 98 115

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 12- 24

Nodhead Store Forecasts

Year
1 2 3 4 5 6
Cash flow
PV, at start of year, 10 percent
discount rate 1000 1000 901 741 517 271
PV, at end of year, 10 percent
discount rate
Economic depreciation 0 100 160 224 246 271
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

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 12- 25

Nodhead Peer Book ROI

Year
1 2 3 4 5 6

Book Income for store

1 -67 33 83 131 131 131
2 -67 33 83 131 131
3 -67 33 83 131
4 -67 33 83
5 -67 33
6 -67
Total book income -67 -34 49 180 311 442

Book value for store

1 1000 833 667 500 333 167
2 1000 833 667 500 333
3 1000 833 667 500
4 1000 833 667
5 1000 833
6 1000
Total book value 1000 1833 2500 3000 3333 3500

Book ROI for all

stores -0.067 -0.019 0.02 0.06 0.093 0.126

EVA for all stores -167 -217 -201 -120 -22 92

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 12- 26

Nodhead Growth v. Return

Rate of Return
(%)

12
11
Economic rate of return
10
9
8
7
Book rate of return

5 10 15 20 25 Rate of Growth
(%)

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 12- 27

Web Resources
Click to access web sites
Internet connection required

www.sternstewart.com

www.emblemsvag.com/economic_profit.htm

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