[3] Agency

Question 1

Who are the principles?
Who are the agents?
Who has more information?
What is the principle-agent problem?

Answer 1

Shareholders (principals) = Owners

Managers (agents) = Employees

Managers have the power to manage day-to-day aspects of the firm.

Managers have more information than the shareholders.

Agency problems occur when managers do not act in the shareholders’ interest.

Question 2

What inefficiences would occur if managers were paid a fixed salary? [6]

Answer 2

• > reduced effort - low incentive to find and invest in truly valuable (+NPV) projects;
• > perks - take nonpecuniary private benefits anyway (company car, lavish office, meetings in luxury resorts,…)
• > empire building - prefer running large business rather than small ones (may not be +NPV). Results in overinvesting.
• > insufficient disinvestment – reluctance to disinvest, e.g. close loss-making business. Results in overinvesting.
• > entrenching investment - choose investments that require or reward the skills of the existing managers.
• > risk-aversion - try to avoid risk or more risky projects.

Question 3

Why does the Principle-agent problem not stop at the top?

Answer 3

Top managers are also principals vis-a-vis the rest of the firm (middle managers and other employees).

Top management must try to ensure that middle managers and employees have the right incentives to find and invest in +NPV projects.

Question 4

What types of incentives are there for managers? 3

Answer 4

Monitoring, Stock-price performance, compensation management

Question 5

What does monitoring incentive entail?

Whats the issue with it? x2

Answer 5

Monitoring: Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course (shareholders, board of directors, auditors, lenders, takeovers…).

But monitoring also involve costs and diminishing returns…

Question 6

What is compensation management incentive?

What is it based upon?

Answer 6

compensation plans must be designed to attract competent managers and to give them the right incentives.

The amount of compensation may be less important than how it is structured.
The compensation package should encourage managers to maximize shareholders’ wealth.
Compensation should be based on:
input (managers’ effort) and
output (incomes or value-added from managers’ actions)
Very difficult to monitor the actions (effort) of managers so compensation should be based on output.

Question 7

What are the trends for manager compensations over time? x3

Answer 7

Since ‘92:
Base salary falling
Bonus roughly the same
Ristricted stocks increasing

Question 8

What is stock-price performance incentive?
What does it reduce? x2
What are stock options, restricted stock and performance shares?

Answer 8

Capital markets do monitor managers’ actions through the price mechanism (stock prices reflect performance of a firm).
Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.
Most major companies link part of their executive pay to the stock-price performance:
- stock options - give managers the right, but not the obligation, to buy their company’s shares in the future at a fixed exercise price;
- restricted stock - stock that must be retained for several yrs;
- performance shares - shares awarded only if the company meets an earnings or other target.

Question 9

Major pitfall of Stock-price performance compensation?

Answer 9

Changes in the stock price aren’t necessarily due to the manager/agent and change due to things outside the managers control

Question 10

4 Reasons why stock price may not reflect manager performance?

Answer 10

• payoffs do not account for stock-price changes relative to the market or to stock prices of other firms in the same industry.
• company’s stock price depends on investors’ expectations of future earnings ⟹ rates of return depend on how well the company performs relative to expectations;
• incentive plans may tempt managers to withhold bad news or manipulate earnings to pump up stock prices;
• stock options can encourage excessive risk-taking (gambling for redemption).

Question 11

Compensation also depends on….

Answer 11

Compensation depends on accounting measures (accounting profits, earnings, rate of return on investment)

Question 12

3 Disadvantages of using Absolute Accounting measures?

Answer 12

• managers tempted to pump up short term profits, leaving longer run problems to successors
• Accounting earnings can be biased measures of true profitability (they calculate income differently, using book value, which doesn’t account for opp cost/NPV)
• Growth in earnings does not necessarily mean that shareholders are better off (ie earnings from some projects that do not have +ve NPV)

Question 13

2 Tech for overcoming the Problems of the Accounting measure of performance:

Answer 13

1. Net Return On Investment
2. Economic Value Added (Residual Income)

Both of these account for the Cost Of Capital

Question 14

How to you calculate Net Income?

Answer 14

Sales

less ‘cost of goods sold (including Depreciation)’

less ‘expenses’

then less ‘25% tax’

= net income

Question 15

Formula to calculate Return on Investment

Answer 15

ROI = Net (or after tax ) Income / Net (depreciated ) book value of Assets

Question 16

The Net ROI is a % and ignores the ____ of the company (and ROI, itself, ignores the ___ ___ ____).
EVA recognizes the amount of ____ ____ and the number of pounds of additional ____ created.
EVA’s message — invest if and only if the increase in ____ is enough to cover the ___ _____ _____.

Answer 16

scale, cost of capital
capital employed, wealth
earnings, cost of capital

Question 17

What is Economic profit the same as?

How is it calculated?

Answer 17

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital (10%):

EP = (ROI -r ) x Capital Invested

Question 18

x5 Advantages of Ecnomic Profit/Economic Value Added?

Answer 18

(+) EVA encourages managers and employees to concentrate on increasing value, not just on increasing earnings;
(+) Managers are motivated to only invest in projects that earn more than they cost;
(+) EVA implies delegated decision making (if you tie managers’ compensation to EVA, you must also give them power over decisions that affect EVA)
(+) EVA makes cost of capital visible to managers (accounting income takes no account of the cost of the capital);
(+) Leads to a reduction in assets/capital employed.

Question 19

x2 Limitations of EVA/EP?

Answer 19

(-) Difficult to judge whether a low EVA is a consequence of bad management or of factors outside the manager’s control;

(-) EVA does not measure present value (EVA and ROI can be negative in the start-up years, even if the project were on track to a strong positive NPV);

Question 20

How to calculate present economic vincome?

Formula for Rate of Return?

Answer 20

= cash flows - economic depreciation

RoR = Economic Income / Original Price

Question 21

What are 2 key rpoblems with using economic income?

Answer 21

You can observe market value if the asset is actively traded, but few plants, divisions, or capital projects have shares traded in the stock market.

You can observe the present market value of all the firm’s assets but not of any one of them taken separately.

Question 22

What do firms use instead of Present Value measure?

Formula to calculate this?

Answer 22

Book Value = original cost - book depreciation

As book depreciation and economic depreciation are usually different, then book earnings will not measure true earnings.

Question 23

Accounting measures are distorted due to use of ____ ____.

Book__ ___ ___ gives a distorted view of the firm’s performance.

Book ____ is an arbitrary method used by accountants that has no bearing on the change in value of the ___

These biases do not work-out in the ___ ____!

Answer 23

book values
RoR
depreciation, assets
long run

Question 24

____ may not always act in shareholders’ ___ ____: ____ ____ problem arise.

Monitoring is imperfect: incurs ___ and ____ ____.

Management compensation can be tied to __-__ performance

_____measures of performance linked to lower level managers.

___ ___ ___ & ___ ____ ___ ___ account for cost of capital, thereby overcoming accounting measures of performance problems.

__ ___ ___ ____ better represents firm’s performance.

Answer 24

Managers, best interest, principal-agent
costs, deminishing returns
stock-price
Accounting
EVA, Net ROI
Economic RoR