WEEK 3 - Agency Problems, Compensation and Performance Measurement Flashcards
(29 cards)
When do agency problems occur? (Principal agent problem)
When the managers do not act in the shareholder’s interests
Why is it so important that the managers (principal) act in the interests of the shareholders (agents)?
- Managers have power to manage day to day aspects of firm
- Managers have more info than shareholders
What incentive system doesn’t work to prevent principal agent problems?
Paying managers fixed salary.
No bonuses, no stock options
What happens if you only pay managers a fixed salary?
- 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
How does the principal agent problem also affect top management?
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
Why is it that we cannot just let top manager make all the important investment decisions?
- 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
How is monitoring an incentive that can be used to counter the principal agent problem?
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…
How is management compensation an incentive that can be used to counter the principal agent problem?
Monitoring imperfect so compensation plans designed to attract best managers and give them right incentives
What should the compensation package include and encourage?
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)
Why is stock price performance considered an incentive that can be used to counter the principal agent problem?
Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.
What are the three types of stocks compensations?
- 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.
What are the downsides to using stock price performance as an incentive to principal agent?
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).
What else does compensation packages depend on?
Depends on accounting measures (accounting profits, earnings, return on investment)
What are the advantages of accounting measures of performance?
- 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
What are the disadvantages of accounting measures of performance?
- Temptation to pump up short term profits, leaving longer run problems to successors
- Accounting earnings can be biased measures of true profitability
- Growth in earnings does not necessarily mean that shareholders are better off (i.e. earnings from some projects that do not have +NPV)
What are the techniques for overcoming the problems in accounting measures of performance?
- Net Return on Investment
- Econ value added (Residual Investment) (EVA)
What is the Net ROI and EVA?
These two methods judge whether the plants returns are higher than the cost of capital
How do you calculate the Net ROI?
Net (after tax) income / Net (depreciated) book value of assets = ROI
What is the Residual Income or EVA?
Net pound return after deducting (a charge for) the cost of capital
What are the differences between Net ROI and EVA?
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.
What is Economic Profit?
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
What are the advantages to EVA?
-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.
What are the limitations to EVA?
- 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)
How do we calculate the Rate of Return?
Cash receipts + Change in price / Beginning price = C1 + (P1 - P0) / P0 or C1 + (PV1 - PV0)/ PV0
- The numerator called the economic income
