WEEK 3 - Agency Problems, Compensation and Performance Measurement

Question 1

When do agency problems occur? (Principal agent problem)

Answer 1

When the managers do not act in the shareholder’s interests

Question 2

Why is it so important that the managers (principal) act in the interests of the shareholders (agents)?

Answer 2

• Managers have power to manage day to day aspects of firm

- Managers have more info than shareholders

Question 3

What incentive system doesn’t work to prevent principal agent problems?

Answer 3

Paying managers fixed salary.

No bonuses, no stock options

Question 4

What happens if you only pay managers a fixed salary?

Answer 4

• Reduced effort - Low incentive to find valuable projects
• Taking unnecessary perks anyway
• Empire Building - Overinvesting to try and build a big company
• Insufficient Disinvestment - Reluctance to disinvest e.g close loss making business
• Entrenching investment - Choose investments that reward managers current skills
• Risk Aversion

Question 5

How does the principal agent problem also affect top management?

Answer 5

They are also principals just like other employees

They must ensure that middle managers and employees have right incentive to find and invest in +NPV Projects

Question 6

Why is it that we cannot just let top manager make all the important investment decisions?

Answer 6

• Too many projects for top management to analyse - Dif to make intelligent decisions
• Details beyond view of execs
• Many decisions/investments don’t appear in capital budget

Question 7

How is monitoring an incentive that can be used to counter the principal agent problem?

Answer 7

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…).

Who does it? - Shareholders,lenders as at time - If take over than another organisation can do

But monitoring also involve costs and diminishing returns…

Question 8

How is management compensation an incentive that can be used to counter the principal agent problem?

Answer 8

Monitoring imperfect so compensation plans designed to attract best managers and give them right incentives

Question 9

What should the compensation package include and encourage?

Answer 9

Should encourage managers to maximise shareholders wealth
Should be based on:
- Input (manager’s effort) (difficult to monitor)
or/and
- Output (Incomes or value added from managers actions) (better option)

Question 10

Why is stock price performance considered an incentive that can be used to counter the principal agent problem?

Answer 10

Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.

Question 11

What are the three types of stocks compensations?

Answer 11

• 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 12

What are the downsides to using stock price performance as an incentive to principal agent?

Answer 12

The performance may depend on events outside of manager’s control

• payoffs do not account for stock-price changes relatively 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 13

What else does compensation packages depend on?

Answer 13

Depends on accounting measures (accounting profits, earnings, return on investment)

Question 14

What are the advantages of accounting measures of performance?

Answer 14

• Based on absolute performance rather than on performance relative to investors expectations
• Make it possible to measure the performance of junior or lower lvl managers whose responsibility extends to only a single division or plant

Question 15

What are the disadvantages of accounting measures of performance?

Answer 15

1. Temptation to pump up short term profits, leaving longer run problems to successors
2. Accounting earnings can be biased measures of true profitability
3. Growth in earnings does not necessarily mean that shareholders are better off (i.e. earnings from some projects that do not have +NPV)

Question 16

What are the techniques for overcoming the problems in accounting measures of performance?

Answer 16

• Net Return on Investment

- Econ value added (Residual Investment) (EVA)

Question 17

What is the Net ROI and EVA?

Answer 17

These two methods judge whether the plants returns are higher than the cost of capital

Question 18

How do you calculate the Net ROI?

Answer 18

Net (after tax) income / Net (depreciated) book value of assets = ROI

Question 19

What is the Residual Income or EVA?

Answer 19

Net pound return after deducting (a charge for) the cost of capital

Question 20

What are the differences between Net ROI and EVA?

Answer 20

Similarity:
- ROI = COC - Net ROI = 0 and EVA = 0

• But the Net ROI is a % and ignores the scale of the company (and ROI, itself, ignores the cost of capital).
• EVA recognizes the amount of capital employed and the number of pounds of additional wealth created.
• EVA’s message — invest if and only if the increase in earnings is enough to cover the cost of capital.

Question 21

What is Economic Profit?

Answer 21

Gives same result as EVA

Capital Invested multiplied by spread between return on investment and the cost of capital (10%)

Calculated by: EP = (ROI -r) x Capital Invested

Question 22

What are the advantages to EVA?

Answer 22

-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 23

What are the limitations to EVA?

Answer 23

• Difficult to judge whether a low EVA is consequence of bad management or of factors outside the managers control
• Does not measure PV (EVA and ROI can be negative in the start up years even if the project were on track to a strong positive NPV)

Question 24

How do we calculate the Rate of Return?

Answer 24

Cash receipts + Change in price / Beginning price = C1 + (P1 - P0) / P0 or C1 + (PV1 - PV0)/ PV0

• The numerator called the economic income

Question 25

How do we calculate economic income?

Answer 25

Cash flow + Change in present value

Question 26

What does a reduction in PV represent for the economic income?

Answer 26

Represents economic depreciation, any increase in PV represents neg econ depreciation

So, econ income = Cash flow - Econ depreciation

Question 27

What is the problem in measuring economic income calculating PV?

Answer 27

Problem in calculating PV
- 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 28

What are the biases of accounting measurements?

Answer 28

• Accounting measures distorted due to use of book values
• Book RoR gives a distorted view of the firm’s performance
• Book depreciation is an arbitrary method used by accountants that has no bearing on the change in the value of the assets
• These biases don’t work long run

Question 29

EXAMPLES AND PRACTISE QUESTIONS ON SLIDE

Answer 29

DO THEM