Chap 12 Flashcards
Why do we care about incentives, and what is the goal of incentives?
- Top management must try to ensure that middle management and employees have the right incentives to find and invest in positive NPV projects.
Why do we need middle management? Why can’t the CFO do all the decision making?
- Top management can’t analyze every project on their own.
- Top management can’t know everything about a particular project.
- Many capital investments don’t appear in the capital budget (ex. R&D)
- Small decision add up.
- CFO may be subject to the same temptations that affect lower management.
What are some temptations managers may face?
- Reduced Effort
- Perks: There may not be any bonuses or perks to performing well.
- Empire building: May prioritize getting size rather than profitability
- Entrenching Investment: Projects may be designed to reward the skills of existing managers.
What is the idea behind “Empire Building”?
Other things equal, managers prefer to run large businesses rather than small ones. Getting from small to large may not be a positive-NPV undertaking. Managers are also reluctant to dismantle their empires. That is, they are reluctant to disinvest.
What is an “Entrenching Investment”?
Projects designed to require or reward the skills of existing managers are called entrenching investments.
Suppose manager Q considers two expansion plans. One plan will require a manager with special skills that manager Q just happens to have. The other plan requires only a general-purpose manager.
What is “overinvesting”? and what lead to it?
Investing beyond the point where NPV falls to zero
Entrenching investments and empire building are typical symptoms of over-investment.
What is the free cash flow problem?
The temptation to overinvest is highest when the firm has plenty of cash but limited investment opportunities
This is called the free cash flow problem
On balance are managers more or less risk averse than shareholders, and why?
Because managers cannot diversify their risks as readily as the shareholders, one might expect them to be too risk-averse. Indeed, evidence suggests that managers seek a “quiet life” when the pressure to perform is relaxed.
What are some reasons why Managers would want to take risks?
Managers who reach top ranks must have taken some risk along the way.
- Managers who are compensated by stock options have more incentive to take risk.
- Managers sometimes have nothing to lose by taking risks.
- Organizations often hesitate to curtail risky activities that lead to big profits.
What is “gambling for redemption”?
- Gambling for Redemption: Taking a huge risk to save your job, you’re gonna get fired anyway might as well try.
Why do firms monitor?
Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course.
Explain the diminishing returns of Monitoring?
- Limit is soon reached at which an extra dollar spent on monitoring would not return an extra dollar of value from reduced agency costs
- Monitoring can’t reduce all agency costs.
- How can you be sure we’re taking ALL positive NPV projects, and NO negative
Who does most of the Monitoring in large corporations?
Board of Directors
- They do most of the monitoring in large corporations - When managers are not up to the job the board will usually step in. - It is better to have more independent board members (not from management)
What type of opinions do Auditors issue?
If the audit uncovers no problems, the auditors issue an opinion that the financial statements fairly represent the company’s financial condition and are consistent with Generally Accepted Accounting Principles (GAAP)
If issues are found and acceptable changes are not made, the auditors will issue a qualified opinion, which is bad news for the company and its shareholders. A qualified opinion suggests that managers are covering something up and undermines investors’ confidence.
Why and how do lenders monitor?
When a company takes out a large bank loan, the bank tracks the company’s assets, earnings, and cash flow. By monitoring to protect its loan, the bank generally protects shareholders’ interests also.
How to shareholders monitor?
If they believe that the corporation is underperforming and that the board is not holding managers to task, they can attempt to elect representatives to the board to make their voices heard
How can a smaller shareholder monitor and how does it affect management?
If they are disgruntled, they can sell out and move on to other investments.
If enough shareholders bail out, the stock price tumbles. This damages top management’s reputation and compensation.
Why would a rival company want to monitor?
- Rival companies may see an opportunity to take over the company and replace it’s management.
What country pays executives the most?
- The US has unusually high levels of executive pay. CEOs in the States receive nearly double the pay of Germany CEOs and 5x of Japanese CEOs
- Although CEO compensation in the US fell during the 2008-2009 crisis, there has been a strong upward trend.
Why would we want to pay CEOs a lot of money?
- High levels of CEO pay encourages CEOs to work hard and make middle management want to pursue that position.
- Sometimes it’s worth it. Ex. If a good CEO can lead to an increase in 1% of stock price of a 10 billion dollar company, it’s worthwhile to pay $20 million for them.
What makes up most of Executive compensation?
- A large and increasing fraction of CEO compensation comes from variable bonuses, stock options, and long term incentives Stock Options, Restricted Stock (Stock that must be retained for several years) Performance Shares (Shares awarded only if company hits a certain target)
What is incentive compensation?
- Compensation package should encourage managers to maximize shareholder wealth.
- Should be based on output and performance
- Use things like stock options.
What is the downside of stock options and incentivized compensation?
- Based on absolute change in stock price, meaning you bear market risk.
- Rates of return depend on how well company performs in regards to expectations, a company can perform really well, but if it was expected to perform really well, there is little reward.
- Incentive plans tempt managers to withhold bad news or manipulate earnings to pump up stock prices. Also may hold off on a project if it will hurt earnings in the short term.
- Stock options encourage excessive risk taking.
What are the benefits of using accounting measures to determine middle management compensation?
- They are based on absolute performance, rather than on performance relative to investor’s expectations
- They make it possible to measure the performance of junior managers whose responsibility extends to only a single division or plant, rather than the stock of the company as a whole.
What are two measures for rewarding performance?
Net Return on Investment: Is the ROI higher than the cost of capital? By how much?
Residual Income or Economic Value Added (EVA): What are earnings after deducting a charge for the cost of capital?
Why do we care about Economic Value Added?
- Need to ensure that we are making not only a return OF our investment, but also a return ON that investment.
- EVA recognizes the amount of capital employed and the number of wealth created.
What is the formula for EVA?
EVA = Residual Income = Income Earned – Income Required
= Income Earned – Cost of Capital * Investment
What is the formula for Economic Profit?
Economic Profit (EP) = (ROI – r) x Capital Invested
What are the pros of EVA?
- Clearly better than earnings or earnings growth for measuring performance.
- Substitute for explicit monitoring by top management, instead of telling them not to waste capital, reward them based on EVA.
What are the cons of EVA?
- How can you judge whether low EVA is a fault of management or outside circumstances?
- Uses accounting data which has further downsides.
- Startups or new drug discoveries may have a
positive NPV but a negative EVA to start.
- Can show accounting losses but from an
economic standpoint be in a good position.
What are the formulas for Economic Income?
Economic Income = Cash Flow + Change in PV
Economic Income = Cash Flow – Economic Depreciation
Why does Accounting Info suck for measuring earnings?
Accountants rarely even attempt to measure present value. Instead they give us net book value (BV), which is original cost less depreciation computed according to some arbitrary schedule. If book depreciation and economic depreciation are different (they are rarely the same), then book earnings will not measure true earnings.
What are some things we can do to reduce biases in accounting profitability measure?
- Ideally the manager should identify and eliminate accounting biases before calculating EVA or net ROI.
- Ex. They may look at R&D as an investment
rather than an expense.
- Ex. They may look at R&D as an investment
- Try to adjust book value to become closer to economic value.
- Try to set up an accounting depreciation schedule that closely matches economic depreciation.
What is meant by the “tyranny of EPS”
- CEO’s complain about the tyranny of EPS, how they are scrutinized by everyone for failing to increase EPS.
- Security analysts forecast earnings per share (EPS) and investors, security analysts, and professional portfolio managers wait to see whether the company can meet or beat the forecasts.
- Most top managers said accounting earnings were the single most important number reported to investors.
What do managers do about earnings targets?
- Most admit to adjusting their firm’s operations and investments to manage earnings.
- They cut back on R&D, Advertising etc. or store away profits to use for a rainy day.
- Many managers were also prepared to defer or reject investment projects with positive NPVs.
