Week 2 slides

Question 1

On what is the focus with performance measures (Result controls)

Answer 1

On the outcome of employees actions.

Question 2

When do you want to use PM?

Answer 2

When employee actions cannot be observed

Question 3

What is the ideal PM?

Answer 3

Individual contribution to firm, but this doesn’t exist, so we chose suboptimal second best.

Question 4

What formula is used for evaluation of PM?

Answer 4

Firm value = Z
Measure (Y) = a*effort + e

Z = Firm value
Y = PM
effort: amount of effort by employee
a = sensitivity, the higher the better
e = external factors, negative factor

Question 5

What does a good PM do?

Answer 5

Closely reflect the employee’s effort while minimizing the impact of noise or factors outside their control

Question 6

What are the 4 criteria to evaluate PMs?

Answer 6

• Sensitivity: to what extent can employee inlfuence measure (a)
• Noise: to what extent is measure influenced by other external factors
• Congruence: to what extent does increase in measure lead to increase in firm value
• Manipulation: to what extent is the measure susceptible to manipulation.

Question 7

What describes financial PM?

Answer 7

• Summarizes broad set of actions of manager in one comprehensive PM
• Reflects the aggregate, bottom-line impact of multiple performance areas
• Aggregate PM facilitates autonomy at lower-levels.

Question 8

What are the 2 types of FPM?

Answer 8

Market measures and Accounting measures

Question 9

What describes market measures?

Answer 9

Forward looking (based on future CF)
- Market incorporates current actions of manager
- May reward anticipated behavior
- manager can influence stock price with strategic information disclosure.

Question 10

What is the evaluation of market measures?

Answer 10

Sensitivity: good for executives, not for lower-level
Noise: high, strong impact external factors –> Much risk imposed on managers
Congruence: best

Question 11

What describes accounting measures?

Answer 11

• Available at many levels (eg firm/divisional profit)
• Accounting typically focused on realized gains and losses (backward looking)
• Translation of economic events in accounting reporting system regulated.

Question 12

What does accounting allow you to do that market doesnt?

Answer 12

Accounting allows measurement at lower-level functions.

Question 13

What is the evaluation of APM?

Answer 13

• Sensitivity: Good, reward at appropriate level
• Noise: better,
• Manipulation, better: accounting principles & auditor
• Congruence: weak
• Ignore externalities: non included, but might be important (sustainability)

Question 14

What describes the weak congruence of APM?

Answer 14

• Backward looking
• Poor match current investments and future benefits (conservative accounting)
• Price leads earnings
• Ignores IA

Question 15

What can control systems result in relating to APM?

Answer 15

Control system can make you make decisions that are not in the best interest of the firm.

Question 16

What are the 4 APM?

Answer 16

• Gaap earnings
• ROI (ROA, ROE)
• Residual income (RI)
• Economic value added (EVA)

Question 17

What can be said about GAAP Earnings

Answer 17

• Absolute measure, does not take use of resources into account –> cannot compare NI between segments of different sizes
• No CoE taken into account
  –> overinvestment if NI of project < CoE

Question 18

What can be said about ROI?

Answer 18

• Managers accept if ROI P > ROI current, but should when R > CoC
  Can result in underinvestment
• Using net value of assets implies ROI increases over time
  Can result in postponing investments or retaining current assets beyond useful life.

Question 19

What is the formula for RI?

Answer 19

RI = OI * (CoC * Capital invested)

Question 20

What does RI solve?

Answer 20

THe underinvestment problem of ROI, gives incentive to invest in all projects that generate returns > CoC.
Incentives are congruent again.

Question 21

What are the downsides of RI?

Answer 21

• Susceptible to accounting shortcomings –> investments lower RI, underinvestment
• What is appropriate CoC (risk profile, shareholder return)
• Cannot compare RI of segments of different sizes.

Question 22

What is the formula for EVA?

Answer 22

EVA = modified profit - (WACC * Modified total capital)

Question 23

What are the advantages of EVA?

Answer 23

• Can increase decision making with more long-term focus
• Can incentive managers to pursue long term value creation and limit short-termism
• Useful for firms with high IA

Question 24

What are the main problems with using profit per share as a PM?

Answer 24

• Focus on short term performance (quarter focus)
• Constantly trailing expectations of the market
• Does Not include CoE, only CoD

Question 25

What are the consequences of using subjectivity as a PM?

Answer 25

Managers focus more on personal relationships and less on the results of the company.

Question 26

What does EVA aim to achieve over market PM and APM?

Answer 26

EVA can solve the problems of traditional earnings measures relatively well.
- EPS problem is solved (CoE focus)
- Totally objective
- Capital market problem is solved

Question 27

Why do you only include important changes into EVA calculation?

Answer 27

Everything you add leads to additional administrative workload, so you might limit number of EVA centers.

Question 28

What consideration is made when considering to use 1 or many EVA centres?

Answer 28

If you use just one, the BU has limited impact on the numbers so sensitivity is low.

If you use many, it leads to much work

Question 29

Why is EVA particularly important for companies that require high investments?

Answer 29

You want a PM that is congruent. You want to avoid punishing investments. EVA does not punish investments