Chapter 12

AGENCY PROBLEMS,
COMPENSATION, AND
PERFORMANCE MANAGEMENT

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
OVERVIEW QUESTIONS

What is a principal-agent relationship?

What is an agency problem?
What are agency costs?
How can agency problems be reduced?

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12-1 INCENTIVES AND COMPENSATION

What is an agency problem?

Mainly refers to the principal-agent
problem, i.e. the conflict of interest between
Shareholders = Owners = Principal
Managers = Employees = Agent

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12-1 INCENTIVES AND COMPENSATION

It is difficult for managers to maximize firm

value, even of they wanted to, for the
following reasons:
Too many projects for top management to analyze
Details are beyond the view of top executives
Many decisions are not in capital budget, such as
R&D, training
Small decisions add up
Executives are subject to human error

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12-1 INCENTIVES AND COMPENSATION

Agency Problems in Capital Budgeting

Reduced effort shirking, simply lazy
Perks seeking personal benefits, comfort
Empire building hubris behavior
Entrenching investment personal interest

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12-1 INCENTIVES AND COMPENSATION

Incentives for taking risk:

Managers must take some risks to be
successful in their career
Managers compensated with stock options
have incentive to take risk
When faced with a situation gambling for
redemption
Organizations hesitate to curtail successful risky
activities e.g. the subprime crisis, Barings
securities
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12-1 INCENTIVES AND COMPENSATION

Monitoring to reduce agency costs

Board of Directors
Sarbanes-Oxley Act requires more independent
directors
Malaysian Code of Corporate Governance, 1/3 of
board should be independent directors
Auditors
Ensure consistency with generally accepted
accounting principles (GAAP)
Lenders
Bank tracks companys assets 12-7
12-1 INCENTIVES AND COMPENSATION

Market Monitoring/ Discipline

Shareholders
can take Wall Street Walk i.e. dispose the shares
This may lead to depression in share prices

Rival Companies
Can take over poorly run businesses
Good managers may leave poorly run companies

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12-1 INCENTIVES AND COMPENSATION

Management Compensation - how best to

pay managers to:
Reduce agency cost
Reduce need for monitoring
Maximize shareholder value

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FIGURE 12.1 U.S. CEO COMPENSATION (2010)

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FIGURE 12.2 GROWTH IN CEO COMPENSATION

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12-1 INCENTIVES AND COMPENSATION

Monitoring Pay for Performance

Design compensation scheme so that it is:
Reasonable, acceptable, motivating
Linked to performance
SEC and NYSE require independent
compensation committees
MCCG requires setting up of compensation
committees at board level

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 Linking pay to performance
What pay?
Basic salary?
Performance bonus?
ESOS?

How to measure performance

Accounting measure
Residual income

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MEASURING PERFORMANCE

Accounting measures
Accrual-based not cash, not value
Focus on short-term performance
Example: Net Income, ROI, ROA

Residual income measure

Earnings after deducting for the cost of capital
Example: EVA

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12-2 RESIDUAL INCOME AND EVA

EVA: Economic Value Added

Attempts to overcome errors in accounting
measurements of performance
Emphasizes NPV over accounting standards
More focus on long-term than short-term
More closely tracks shareholder value than
accounting measurements
Formula:
EVA = NOPAT - (Invested Capital x WACC)

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WHAT IS 'ECONOMIC VALUE ADDED - EVA'
Economic value added (EVA) is a measure of a
company's financial performance based on the
residual wealth calculated by deducting its cost of
capital from its operating profit, adjusted for taxes
on a cash basis.
EVA can also be referred to as economic profit,
and it attempts to capture the true economic profit
of a company.
This measure was devised by Stern Stewart and
Co.

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TABLE 12.1 STATEMENTS OF INCOME, QUAYLE
CITY PLANT (PAGE 305)

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12-2 RESIDUAL INCOME AND EVA

Quayle City Plant ($million)

130
ROI .13
1,000

Given COC = 10%

Net ROI 13% 10% 3%

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12-2 RESIDUAL INCOME AND EVA

Residual Income, or Economic Value

Added (EVA).
What are earnings after deducting a charge
for the (dollar) cost of capital?
EVA residual income
income earned income required
income earned cost of capital investment

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12-2 RESIDUAL INCOME AND EVA

Quayle City Plant ($million)

Given COC = 10%

EVA residual income
130 (.10 1,000)
$30 million

What if the COC is 20%?

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12-2 RESIDUAL INCOME AND EVA

Economic Profit
Capital invested times spread between return
on investment (ROI) and cost of capital (COC)
Result in similar answer to EVA

EP economic profit
(ROI r ) capital invested

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12-2 RESIDUAL INCOME AND EVA

Quayle City Plant ($Million)

COC = 10%

EP (ROI r ) capital invested

(.13 .10) 1,000
$30 million

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12-2 RESIDUAL INCOME AND EVA
Pros and Cons of EVA
Pros
Managers motivated to invest in projects that earn more
than they cost seeking positive NPV projects
Makes cost of capital visible to managers
Leads to reduction in assets employed
Cons
Does not measure present value
Rewards quick paybacks
Ignores time value of money

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12-2 RESIDUAL INCOME AND EVA

EVA Example
Movie generates $30 million net income during 4-month
run. Rentals/post-theater income forecasted nominal.
Cost to produce was $100 million. Given 10% cost of
capital, what is EVA of project and was it a good
investment?
EVA 30 (.10 100)
$20 million
EVA is positive, but the project is a loser. In this case
EVA cannot be used.

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12-3 BIASES IN ACCOUNTING
MEASURES OF PERFORMANCE
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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12-3 BIASES IN ACCOUNTING
MEASURES OF PERFORMANCE

ECONOMIC ACCOUNTING
INCOME Cash flow + Cash flow +
change in PV = change in book value =
Cash flow Cash flow
economic depreciation accounting depreciation

Economic income Accounting income

RETURN PV at start of year BV at start of year

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TABLE 12.2 NODHEAD BOOK INCOME AND ROI

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TABLE 12.3 NODHEAD STORE FORECASTS

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TABLE 12.4 NODHEAD PEER BOOK ROI

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NODHEAD GROWTH VERSUS 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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