So far we’ve concentrated on criteria and procedures for identifying capital investments with positive NPVs. If a firm takes all (and only) positive-NPV projects, it maximizes the firm’s value. But do the firm’s managers want to maximize value?
Managers have no special gene that automatically aligns their personal interests with outside investors’ financial objectives. So how do shareholders ensure that top managers do not feather their own nests or grind their own axes? And how do top managers ensure that middle managers and employees try as hard as they can to find and execute positive-NPV projects?
Here we circle back to the principal–agent problems first raised in Chapter 1. Shareholders are the ultimate principals; top managers are the stockholders’ agents. But middle managers and employees are, in turn, agents of top management. Thus, senior managers—including the chief financial officer—are simultaneously agents vis-à-vis shareholders and principals vis-à-vis the rest of the firm. The problem is to get everyone working together to maximize value.
This chapter describes how companies grapple with that problem. We first describe the temptations that can divert managers from maximizing shareholder value and then discuss how those temptations are blocked or at least diluted. Managers’ investment decisions are monitored by auditors, lenders, and regulators, as well as by shareholders. In addition, compensation schemes for top management are designed to give managers the right incentives to increase value.
Top managers in the United States usually receive incentive compensation in the form of grants of stock or options. This helps to align the managers’ and shareholders’ interests, but it may have unpleasant side effects. For example, it can put pressure on managers to worry more about short- rather than long-run returns. We will confront a disturbing fact: It appears that some, maybe most, public corporations seem willing to sacrifice NPV to maintain or increase immediate earnings per share.
Middle managers’ compensation depends mostly on accounting measures of profitability. It’s not absolute profitability that matters, but profitability relative to the cost of capital. We explain how measures of economic value added (EVA) incorporate the cost of capital and thereby mitigate agency problems in lower layers of the firm. At the end of the chapter, we explore the differences between accounting rates of return and true, economic rates of return. You should be aware of the biases that can hide in accounting measures of profitability.
12-1What Agency Problems Should You Watch Out For?
The CEO, CFO, and other managers cannot be perfect agents of their shareholders. The managers are human beings who cannot completely set aside their own interests and concerns. It’s naïve to think that they will find and invest in all and only positive-NPV investments. Agency costs are incurred when they don’t.
Agency costs of investment can’t be eliminated, but they can be mitigated. Managers are monitored by shareholders, banks, and other financial institutions, which push back against inefficient investment and waste. Compensation and other incentives can be designed so that managers are rewarded appropriately when they generate value for the firm. Managers are also constrained by law and regulation from taking actions that damage the shareholders. A good combination of monitoring, incentives, and constraints adds up to good corporate governance.
There will be more on monitoring and management compensation later in this chapter and on corporate governance later in the book. We start here by listing several specific agency problems that can interfere with value-maximizing investment.
· Reduced effort. Finding and implementing positive-NPV projects can be a high-effort, high-pressure activity. Managers may be drawn to slack off.
· Perks. Managers are tempted to spend wastefully on upscale office accommodations, meetings scheduled at luxury resorts, private jets, and so on. Economists refer to these nonpecuniary rewards as private benefits. Ordinary people refer to them as perks.1
· 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.
· Entrenching investment. 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. Guess which plan Q will favor? Projects designed to require or reward the skills of existing managers are called entrenching investments.2
· Overinvestment. Entrenching investments and empire building are typical symptoms of overinvestment—that is, investing beyond the point where NPV falls to zero. The temptation to overinvest is highest when the firm has plenty of cash but limited investment opportunities. Michael Jensen called this the free-cash-flow problem.3
· Insufficient disinvestment. There is also a reluctance to disinvest, especially when jobs are at stake. Sometimes value is added by selling off a factory or product line or closing down a loss-making business. The reluctance to disinvest amounts to overinvestment on the downside.
Agency Problems Don’t Stop at the Top
The CEO, CFO, and other top managers are agents for shareholders as principals. But the top managers must also supervise and set incentives for middle managers. In this case, the top managers are principals and the middle managers agents.
Getting incentives right throughout a large corporation is difficult. So why not bypass these difficulties and let the CFO and his or her immediate staff make the important investment decisions?
The bypass won’t work, for at least four reasons. First, top management would have to analyze thousands of projects every year. There’s no way to know enough about each one to make intelligent choices. Top management must rely on analysis done at lower levels.
Second, the design of a capital investment project involves investment decisions that top managers do not see. Think of a proposal to build a new factory. The managers who developed the plan for the factory had to decide its location. Suppose they chose a more expensive site to get closer to a pool of skilled workers. That’s an investment decision: additional investment to generate extra cash flow from access to these workers’ skills. (Outlays for training could be lower, for example.) Does the additional investment generate additional NPV, compared with building the factory at a cheaper but more remote site? How is the CFO to know? He or she can’t afford the time or the technical knowledge to investigate every alternative that was considered but rejected by the project’s sponsors.
Third, many capital investments don’t appear in the capital budget. These include research and development, worker training, and marketing outlays designed to expand a market or lock in satisfied customers.
Fourth, small decisions add up. Operating managers make investment decisions every day. They may carry extra inventories of raw materials so they won’t have to worry about being caught short. Managers at the confabulator plant in Quayle City, Kansas, may decide they need one more forklift. They may hold on to an idle machine tool or an empty warehouse that could have been sold. These are not big decisions ($25,000 here, $50,000 there), but thousands of such decisions add up to real money.
Risk Taking
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.4 But there are plenty of exceptions.
First, the managers who reach the top ranks of a large corporation must have taken some risks along the way. Managers who seek only the quiet life don’t get noticed and don’t get promoted rapidly.
Second, managers who are compensated with stock options have an incentive to take more risk. As we explain in Chapters 20 and 21, the value of an option increases when the risk of the firm increases.5
Third, managers sometimes have nothing to lose by taking on risks. Suppose that a regional office suffers large, unexpected losses. The regional manager’s job is on the line, and in response, he or she tries a risky strategy that offers a small probability of a big, quick payoff. If the strategy pays off, the losses are covered and the manager’s job may be saved. If it fails, nothing is lost, because the manager would have been fired anyway. This behavior is called gambling for redemption.6
Fourth, organizations often hesitate to curtail risky activities that are delivering—at least temporarily—rich profits. The financial crisis of 2007–2009 provides sobering examples. Charles Prince, the pre-crisis CEO of Citigroup, was asked why that bank’s leveraged lending business was expanding so rapidly. Prince quipped, “When the music stops . . . things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citi later took a $1.5 billion loss on this line of business.
Example: Agency Costs and Subprime Mortgages “Subprime” refers to mortgage loans made to home buyers with weak credit. Some of these loans were made to naïve buyers who then struggled to keep up with interest and principal payments. Some were made to opportunistic buyers who were willing to bet that real estate prices would keep improving so that they could “flip” their houses at a profit. But prices fell sharply in 2007 and 2008, and many buyers were forced to default.
Why did so many banks and mortgage companies make these loans in the first place? One reason is that they could repackage the loans as mortgage-backed securities and sell them at a profit to other banks and institutional investors. It’s clear with hindsight that many buyers of these mortgage-backed securities were, in turn, naïve and paid too much. When housing prices fell and defaults increased, the prices of these securities fell drastically. For example, Merrill Lynch wrote off $50 billion of losses and was sold under duress to Bank of America.
Although there’s plenty of blame to pass around for the subprime crisis, some of it must go to the managers who promoted and sold the subprime mortgages. Were they acting in shareholders’ interests or their own interests? We doubt that their shareholders would have endorsed the managers’ tactics if the shareholders could have seen what was really going on. We think that the managers would have been much more cautious if they had not had the chance for another fat bonus before their game ended. If so, the financial crisis was partly an agency problem, not value maximization run amok.
12-2Monitoring
Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course.
Monitoring can prevent the more obvious agency costs, such as blatant perks. It can confirm that the manager is putting in sufficient time on the job. But monitoring requires time and money. Some monitoring is almost always worthwhile, but a limit is soon reached at which an extra dollar spent on monitoring would not return an extra dollar of value from reduced agency costs. Like all investments, monitoring encounters diminishing returns.
Some agency costs can’t be prevented even with the most thorough monitoring. Suppose a shareholder undertakes to monitor capital investment decisions. How could he or she ever know for sure whether a capital budget approved by top management includes (1) all the positive-NPV opportunities open to the firm and (2) no projects with negative NPVs due to empire-building or entrenching investments? The managers know more about the firm’s prospects than outsiders ever can. If the shareholder could identify all projects and their NPVs, then the managers would hardly be needed!
Who actually does the monitoring?
Boards of Directors
In large, public companies, the task of monitoring is delegated to the board of directors, who are elected by shareholders to represent their interests. Boards of directors are sometimes portrayed as passive stooges who always champion the incumbent management. But response to past corporate scandals has tipped the balance toward greater independence. For example, the Sarbanes-Oxley Act (or SOX) requires that public corporations place more independent directors on the board—that is, more directors who are not managers or are not affiliated with management. In large companies, 85% of all directors are now independent.7
BEYOND THE PAGE
SOX
mhhe.com/brealey13e
When managers are not up to the job, boards frequently step in. In recent years, the CEOs of Ford, CSX, AIG, and Wells Fargo have all been replaced. Boards outside the United States, which traditionally have been more management friendly, have also become more willing to replace underperforming managers. The list of recent departures includes the heads of Cathay Pacific, LafargeHolcim, Toshiba, Marks and Spencer, and Handelsbanken.
Of course, delegation of monitoring to the board brings its own agency problems. For example, many board members may be long-standing friends of the CEO and may be indebted to the CEO for help or advice. Understandably, they may be reluctant to fire the CEO or enquire too deeply into his or her conduct. Fortunately, the company’s directors are not the only people who scrutinize management’s actions. Several other groups serve to keep a wary eye on management.
Auditors
The board is required to hire independent accountants to audit the firm’s financial statements. 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 problems are found, the auditors will negotiate changes in assumptions or procedures. Managers almost always agree because if 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.
A qualified audit opinion may be bad news, but when investors learn of accounting irregularities that have escaped detection, there can be hell to pay. In September 2014, the British supermarket giant Tesco announced that it had discovered material accounting irregularities and had overstated its first half profits by about $420 million. As the scandal unfolded, Tesco’s share price fell by some 30%, wiping $8 billion off the market value of the company.
Lenders
Lenders also 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.8
Shareholders
Shareholders also keep an eagle eye on the company’s management and board of directors. If they think that a corporation is not pursuing shareholder value with sufficient energy and determination, they can try to force change—for example, by nominating candidates to the board of directors.
There is a breed of activist investors who specialize in finding such underperforming companies and trying to convince them to restructure. These include Carl Icahn (Icahn Enterprises), Paul Singer (Elliott Management), Daniel Loeb (Third Point), and Nelson Peltz (Trian Partners). Peltz’s fund bought a large stake in DuPont and was able to force DuPont to cut back its operations and research and development (R&D) and to shed 10% of its worldwide workforce. It agreed to merge with Dow Chemical and to split the merged firm into three new, more focused companies. Other recent targets for activist investors include Navistar, Procter & Gamble, and the food giants Mondelez International and Nestlé. A company’s shareholders appear to welcome the arrival of an activist investor for the announcement of the acquisition of a 5% holding by an activist prompts a 7 to 8% abnormal return on the stock.9
Smaller shareholders can’t play the activist investors’ game, but they can take the “Wall Street Walk” by selling out and moving on to other investments. The Wall Street Walk can send a powerful message. If enough shareholders bail out, the stock price tumbles. This damages top management’s reputation and compensation. A large part of top managers’ paychecks comes from stock grants and stock options, which pay off if the stock price rises but are worthless if the price falls below a stated threshold. Thus, a falling stock price has a direct impact on managers’ personal wealth. A rising stock price is good for managers as well as stockholders.
Takeovers
A company’s management is regularly monitored by other management teams. If the latter believe that the assets are not being used efficiently, then they can try to take over the business and boot out the existing management. We will have more to say in Chapters 31 and 32 about the role of takeovers and the market for corporate control.
12-3Management Compensation
Monitoring can’t be perfect. Therefore, compensation plans must be designed to attract competent managers and to give them the right incentives.
For U.S. public companies, compensation is the responsibility of the compensation committee of the board of directors. The Securities and Exchange Commission (SEC) and New York Stock Exchange (NYSE) require that all directors on the compensation committee be independent—that is, not managers or employees and not linked to the company by some other relationship (e.g., a lucrative consulting contract) that would undercut their independence. The committee typically hires outside consultants to advise on compensation trends and on compensation levels in peer companies.
You can see how the information provided by outside consultants may cause compensation to creep up. The problem is that compensation committees don’t want to approve below-average compensation. But if every firm wants to be above-average, then the average will ratchet up.10
Once the compensation package is approved by the committee, it is described in an annual Compensation Discussion and Analysis (CD&A), which is sent to shareholders along with director nominations and the company’s 10-K filing. (The 10-K is the annual report to the SEC.) In January 2011, the SEC gave shareholders a nonbinding say-on-pay vote on the CD&A at least once every three years.11 The occasional no vote on management compensation is a disagreeable wake-up call for managers and directors. For example, when the shareholders of auto supplier BorgWarner voted “no” in 2015, the company made changes to its compensation program and cut the CEO’s incentive award by $2.4 million.
To reinforce these safeguards we now have two consulting companies, ISS and Glass Lewis, that review CD&As for thousands of companies, looking especially at pay-for-performance standards. Their clients are mostly institutional investors, who seek advice on how to vote. (A mutual fund or pension fund may own shares in hundreds of companies. The fund may decide to outsource the analysis of CD&As to a company that specializes in governance issues.)
Compensation Facts and Controversies
Studies of executive pay in the United States suggest three general features:
1. As you can see from Figure 12.1, U.S. CEOs tend to be more highly paid than their opposite numbers in other countries. On average, they get double the pay of German CEOs and more than five times the pay of Japanese CEOs.
2. Figure 12.2 shows that average compensation in the United States has risen much more rapidly than inflation. Between 1992 and 2016, total compensation for the CEOs of companies in the Standard & Poor’s (S&P) Index has more than tripled in real terms.12
3. Figure 12.3 shows that only 12% of compensation for these CEOs comes from salary. The remainder comes from bonuses, stock grants, stock options, and other performance-linked incentives. This proportion of incentive-based compensation has increased sharply and is much higher than in other countries.
We look first at the size of the pay package. Then we turn to its contents.
FIGURE 12.1 Average annual compensation of CEOs in 2014 by country; https://www.statista.com/statistics/424154/average-annualceo-compensation-worldwide/
FIGURE 12.2 Median total compensation 1992–2016 for CEOs of companies in the S&P Index. Values are shown in inflation-adjusted 2016 dollars.
Source: Execucomp.
FIGURE 12.3 The average percentage of CEO compensation in the form of salaries, bonuses, long-term incentive plans (LTIPs), stock awards, option awards, and other sources. Stock awards and options are valued at the time of the grant. The sample consists of companies in the S&P Index between 1992 and 2016.
High levels of CEO pay undoubtedly encourage CEOs to work hard and (perhaps more important) offer an attractive carrot to lower-level managers who hope to become CEOs. But there has been widespread concern about “excessive” pay, especially pay for mediocre performance. For example, Robert Nardelli received a $210 million severance package on leaving The Home Depot, and Henry McKinnell received almost $200 million on leaving Pfizer. Both CEOs left behind troubled and underperforming companies. You can imagine the newspaper headlines.
Those headlines were even bigger in 2008 when it was revealed that generous bonuses were to be paid to the senior management of banks that had been bailed out by the government. Merrill Lynch hurried through $3.6 billion in bonuses, including $121 million to just four executives, only days before Bank of America finalized its deal to buy the collapsing firm with the help of taxpayer money. “Bonuses for Boneheads” was the headline in Forbes magazine.
It is easy to point to cases where poorly performing managers have received unjustifiably large payouts. But is there a more general problem? Perhaps high levels of pay simply reflect a shortage of talent. After all, CEOs are not alone in earning large sums. The earnings of top professional athletes are equally mouthwatering. The LA Dodgers’ Clayton Kershaw was paid $33 million in 2017. The Dodgers must have believed that it was worth paying for a star who would win games and fill up the ballpark.
If star managers are as rare as star baseball players, corporations may need to pay up for CEO talent. Suppose that a superior CEO can add 1% to the value of a large corporation with a market capitalization of $10 billion. One percent on a stock market value of $10 billion is $100 million. If the CEO can really deliver, then a pay package of, say, $20 million per year sounds like a bargain.13
There is also a less charitable explanation of managerial pay. This view stresses the close links between the CEO and the other members of the board of directors. If directors are too chummy with the CEO, they may find it difficult to get tough when it comes to setting compensation packages.
So we have two views of the level of managerial pay. One is that it results from arms-length contracting in a tight market for managerial talent. The other is that poor governance and weak boards allow excessive pay. There is evidence for and against both views. For example, CEOs are not the only group to have seen their compensation increase rapidly in recent years. Corporate lawyers, sports stars, and celebrity entertainers have all increased their share of national income, even though their compensation is determined by arms-length negotiation.14 However, the shortage-of-talent argument cannot account for wide disparities in pay. For example, compare the CEO of Ford (compensation of $22 million in 2016) to the CEO of Toyota (compensation of about $3 million) or to Fed Chairman Jerome Powell ($200,000). It is difficult to argue that Ford’s CEO delivered the most value or had the most difficult and important job.
The Economics of Incentive Compensation
The amount of compensation may be less important than how it is structured. The compensation package should encourage managers to maximize shareholder wealth.
Compensation could be based on input (e.g., the manager’s effort) or on output (income or value added as a result of the manager’s decisions). But input is difficult to measure. How can outside investors observe effort? They can check that the manager clocks in on time, but hours worked does not measure true effort. (Is the manager facing up to difficult and stressful choices, or is he or she just burning time with routine meetings, travel, and paperwork?)
Because effort is not observable, compensation must be based on output—that is, on verifiable results. Trouble is, results depend not just on the manager’s contribution, but also on events outside the manager’s control. Unless you can separate out the manager’s contribution, you face a difficult trade-off. You want to give the manager high-powered incentives, so that he or she does very well when the firm does very well and poorly when the firm underperforms. But suppose the firm is a cyclical business that always struggles in recessions. Then high-powered incentives will force the manager to bear business cycle risk that is not his or her fault.
There are limits to the risks that managers can be asked to bear. So the result is a compromise. Firms do link managers’ pay to performance, but fluctuations in firm value are shared by managers and shareholders. Managers bear some of the risks that are beyond their control, and shareholders bear some of the agency costs when managers fail to maximize firm value.
Most major companies around the world now link part of their executive pay to the performance of the companies’ stock.15 Sometimes these incentive schemes constitute the major part of the manager’s compensation pay. For example, for the 2017 fiscal year, Larry Ellison, who was CEO of the business software giant Oracle Corporation, received total compensation estimated at $21 million. Only $1 of that amount was salary. The lion’s share was in the form of stock and option grants. Moreover, as founder of Oracle, Ellison holds more than 1 billion shares in the firm. No one can say for certain how hard Ellison would have worked with a different compensation package. But one thing is clear: He has a huge personal stake in the success of the firm—and in increasing its market value.
Stock options give managers the right (but not the obligation) to buy their company’s shares in the future at a fixed exercise price. Usually, the exercise price is set equal to the company’s stock price on the day the options are granted. If the company performs well and stock price increases, the manager can buy shares and cash in on the difference between the stock price and the exercise price. If the stock price falls, the manager leaves the options unexercised and hopes for compensation through another channel.
The popularity of stock options was encouraged by U.S. accounting rules, which permitted companies to grant stock options without recognizing any immediate compensation expense. The rules allowed companies to value options at the excess of the stock price over the exercise price on the grant date. But the exercise price was almost always set equal to the stock price on that date. Thus, the excess was zero and the stock options were valued at zero. (We show how to calculate the actual value of options in Chapters 20 and 21.) So companies could grant lots of options at no recorded cost and with no reduction in accounting earnings. Naturally, accountants and investors were concerned because earnings were overstated in greater numbers as the volume of option grants increased. After years of controversy, the accounting rules were changed in 2006. U.S. corporations are now required to value executive stock options more realistically and to deduct these values as a compensation expense.
Options also used to have a tax advantage in the United States. Since 1994, compensation of more than $1 million has been considered unreasonable and is not a tax-deductible expense. However, until 2018 there was no restriction on performance-based compensation such as stock options. This exemption was removed by the Tax Cuts and Jobs Act of December 2017.
If you look back at Figure 12.3, you will see that the form of incentive compensation has also undergone significant change. During the 1990s, there was a surge in the use of stock options, and by the year 2000, almost half of a CEO’s compensation was typically in the form of options. More recently, companies have increasingly rewarded management with restricted shares or, more commonly, with performance shares. In the former case, the manager receives a fixed number of shares at the end of a vesting period as long as he or she is still with the company. In the latter case, the number of shares that the manager receives is typically related to his or her performance in the interim.
You can see the advantages of tying compensation to stock price either by the grant of options or stock. When a manager works hard to increase the price, he or she helps shareholders as well as herself.The stock price is a noisy, but objective measure of a firm’s financial performance. It is also a forward-looking measure; it incorporates the value of future earnings and future growth opportunities (PVGO). Thus a manager can be rewarded today for ensuring that his or her firm has a good shot at a prosperous future.
But compensation tied to stock price can also have unpleasant side effects. We have already noted how compensation based on stock price forces managers to bear risks that are outside their control. Think of the CEO of an oil company. The company’s earnings and stock price depend on worldwide oil prices. When oil prices took off as they did in 1974, 1980 and the early 2000s, did oil-industry CEOs get an extra compensation for being in the right industry at the right time? Bertrand and Mullainathan found that the answer was Yes. Compensation in the oil industry was closely linked to the level of oil prices. But they also found that the link was weaker when shareholders with large blocks of stock sat on the board of directors. It seems that these shareholders resisted large compensation awards that were based just on good luck.16
Some companies do attempt to take out the effect of luck by measuring and rewarding performance relative to industry peers. For example, the electric utility Entergy bases part of its incentive compensation on how well Entergy stock performs relative to the Philadelphia Index of 20 of the largest U.S. utilities.
A second problem with performance-related pay is that stock prices depend on investors’ expectations of future earnings, and rates of return depend on how well the company performs relative to expectations. Suppose a company announces the appointment of an outstanding new manager. The stock price leaps up in anticipation of improved performance. If the new manager then delivers exactly the good performance that investors expected, the stock will earn only a normal rate of return. In this case, a compensation scheme linked to the stock return after the manager starts would fail to recognize the manager’s special contribution.
Stock options can also encourage excessive risk taking. For example, when stock prices fall precipitously, as they did for many firms in the crisis of 2007–2009, existing stock options can be far “underwater” and nearly worthless. Managers holding these options may be tempted to gamble for redemption.
The Specter of Short-Termism
The fourth imperfection may be the most serious. Managers whose pay depends on the stock price are tempted to withhold bad news or manage reported earnings. They are also tempted to postpone or cancel valuable investment projects if the projects would depress earnings in the short run.
CEOs of public companies face constant scrutiny. Much of that scrutiny focuses on earnings. 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. Not meeting the forecasts can be a big disappointment.
Monitoring by security analysts and portfolio managers can help constrain agency problems. But CEOs complain about the “tyranny of EPS” and the apparent short-sightedness of the stock market. (The British call it short-termism.) Of course, the stock market is not systematically short-sighted. If it were, growth companies would not sell at the high price–earnings ratios observed in practice.17 Nevertheless, the pressure on CEOs to generate steady, predictable growth in earnings is real.
CEOs complain about this pressure, but do they do anything about it? Unfortunately the answer appears to be yes, according to Graham, Harvey, and Rajgopal, who surveyed about 400 senior managers.18 Most of the managers said that accounting earnings were the single most important number reported to investors. Most admitted to adjusting their firms’ operations and investments to manage earnings. For example, 80% were willing to decrease discretionary spending in R&D, advertising, or maintenance if necessary to meet earnings targets. Many managers were also prepared to defer or reject investment projects with positive NPVs.
There is a good deal of evidence that firms do indeed manage their earnings. For example, Degeorge, Patel, and Zeckhauser studied a large sample of earnings announcements.19 With remarkable regularity, earnings per share either met or beat security analysts’ forecasts, but only by a few cents. CFOs appeared to report conservatively in good times, building a stockpile of earnings that could be reported later. The rule, it seems, is Make sure that you report sufficiently good results to keep analysts happy, and, if possible, keep something back for a rainy day.20
How much value was lost because of such adjustments? For a healthy, profitable company, spending a little less on advertising or deferring a project start for a few months may cause no significant damage. But we cannot endorse any sacrifice of fundamental shareholder value done just to manage earnings.
We may condemn earnings management, but in practice it’s hard for CEOs and CFOs to break away from the crowd. Graham and his coauthors explain it this way:21
The common belief is that a well-run and stable firm should be able to “produce the numbers”. . . even in a year that is somewhat down. Because the market expects firms to be able to hit or slightly exceed earnings targets, and on average firms do just this, problems can arise when a firm does not deliver. . . . The market might assume that not delivering [reveals] potentially serious problems (because the firm is apparently so near the edge that it cannot produce the dollars to hit earnings . . .). As one CFO put it, “if you see one cockroach, you immediately assume that there are hundreds behind the walls.”
Thus, we have a cockroach theory explaining why stock prices sometimes fall sharply when a company’s earnings fall short, even if the shortfall is only a penny or two.
Of course, private firms do not have to worry about earnings management—which could help explain the increasing number of firms that have been bought out and returned to private ownership. (We discuss “going private” in Chapters 15, 32, and 33.) Firms in some other countries, where quarterly earnings reports are not required and governance is more relaxed, may find it easier to invest for the long run. But such firms will probably accumulate more agency problems. We wish there were simple answers to these trade-offs.
12-4Measuring and Rewarding Performance: Residual Income and EVA
Almost all top executives of firms with publicly traded shares have compensation packages that depend in part on their firms’ stock price performance. But their compensation also includes a bonus that depends on increases in earnings or on other accounting measures of performance. For lower-level managers, compensation packages usually depend more on accounting measures and less on stock returns.
Accounting measures of performance have two advantages:
1. They are based on absolute performance, rather than on performance relative to investors’ expectations.
2. They make it possible to measure the performance of junior managers whose responsibility extends to only a single division or plant.
Tying compensation to accounting profits also creates some obvious problems. For example, managers whose pay or promotion depends on short-term profits may cut back on training, advertising, or R&D. This is not a recipe for adding value because these outlays are investments that should pay off in later years. Nevertheless, the outlays are treated as current expenses and deducted from current income. Thus, an ambitious manager is tempted to cut back, thereby increasing current income, leaving longer-run problems to his or her successor.
In addition, accounting earnings and rates of return can be severely biased measures of true profitability. We ignore this problem for now, but return to it in the next section.
Finally, growth in earnings does not necessarily mean that shareholders are better off. Any investment with a positive rate of return (1% or 2% will do) will eventually increase earnings. Therefore, if managers are told to maximize growth in earnings, they will dutifully invest in projects offering 1% or 2% rates of return—projects that destroy value. But shareholders do not want growth in earnings for its own sake, and they are not content with 1% or 2% returns. They want positive-NPV investments, and only positive-NPV investments. They want the company to invest only if the expected rate of return exceeds the cost of capital.
Look at Table 12.1, which contains a simplified income statement and balance sheet for your company’s Quayle City confabulator plant. There are two methods for judging whether the plant’s returns are higher than the cost of capital.
Book return on investment (ROI) is just the ratio of after-tax operating income to the net (depreciated) book value of assets.22 In Chapter 5, we rejected book ROI as a capital investment criterion, and in fact, few companies now use it for that purpose. However, managers frequently assess the performance of a division or a plant by comparing its ROI with the cost of capital.
Suppose you need to assess the performance of the Quayle City plant. As you can see from Table 12.1, the corporation has $1,000 million invested in the plant, which is generating earnings of $150 million. Therefore, the plant is earning an ROI of 150/1,000 = .15, or 15%.23 If the cost of capital is (say) 10%, then the plant’s activities are adding to shareholder value. The net return is 15 − 10 = 5%. If the cost of capital is (say) 20%, then shareholders would have been better off investing $1 billion somewhere else. In this case the net return is negative, at 15 − 20 = −5%.
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Income |
Assets at Start of Year |
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Sales |
$550 |
Net working capitalb |
$ 80 |
|
Cost of goods solda |
275 |
Property, plant, and equipment investment |
1,170 |
|
Selling, general, and administrative expenses |
75 |
Less cumulative depreciation |
360 |
|
$200 |
Net investment |
$ 810 |
|
|
Taxes at 25% |
50 |
Other assets |
110 |
|
Net income |
$150 |
Total assets |
$1,000 |
TABLE 12.1 Simplified statements of income and assets for the Quayle City confabulator plant (figures in millions)
a Includes depreciation expense.
b Current assets less current liabilities.
Residual Income or Economic Value Added (EVA®)24
When firms calculate income, they start with revenues and then deduct costs, such as wages, raw material costs, overhead, and taxes. But there is one cost that they do not commonly deduct: the cost of capital. True, they allow for depreciation, but investors are not content with a return of their investment; they also demand a return on that investment. As we pointed out in Chapter 10, a business that breaks even in terms of accounting profits is really making a loss; it is failing to cover the cost of capital.
To judge the net contribution to value, we need to deduct the cost of capital contributed to the plant by the parent company and its stockholders. Suppose again that the cost of capital is 10%. Then the dollar cost of capital for the Quayle City plant is .10 × $1,000 = $100 million.
The net gain is therefore $150 − 100 = $50 million. This is the addition to shareholder wealth due to management’s hard work (or good luck).
Net income after deducting the dollar return required by investors is called residual income or economic value added (EVA). The formula is
For our example, the calculation is
EVA = residual income = 150 − (.10 × 1,000) = +$50 million
But if the cost of capital were 20%, EVA would be negative by $50 million.
Net return on investment and EVA are focusing on the same question. When return on investment equals the cost of capital, net return and EVA are both zero. But the net return is a percentage and ignores the scale of the company. EVA recognizes the amount of capital employed and the number of dollars of additional wealth created.
EVA sometimes pops up with different labels. Other consulting firms have their own versions of residual income. McKinsey & Company uses economic profit (EP), defined as capital invested multiplied by the spread between return on investment and the cost of capital. This is another way to measure residual income. For the Quayle City plant, with a 10% cost of capital, economic profit is the same as EVA:
In Chapter 28, we take a look at EVAs calculated for some well-known companies. But EVA’s most valuable contributions happen inside companies. EVA encourages managers and employees to concentrate on increasing value, not just on increasing earnings.
Pros and Cons of EVA
Let us start with the pros. EVA, economic profit, and other residual income measures are clearly better than earnings or earnings growth for measuring performance. A plant that is generating lots of EVA should generate accolades for its managers as well as value for shareholders. EVA may also highlight parts of the business that are not performing up to scratch. If a division is failing to earn a positive EVA, its management is likely to face some pointed questions about whether the division’s assets could be better employed elsewhere.
EVA sends a message to managers: Invest if and only if the increase in earnings is enough to cover the cost of capital. This is an easy message to grasp. Therefore, EVA can be used down deep in the organization as an incentive compensation system. It is a substitute for explicit monitoring by top management. Instead of telling plant and divisional managers not to waste capital and then trying to figure out whether they are complying, EVA rewards them for careful investment decisions. Of course, if you tie junior managers’ compensation to their economic value added, you must also give them power over those decisions that affect EVA. Thus, the use of EVA implies delegated decision making.
EVA makes the cost of capital visible to operating managers. A plant manager can improve EVA by (1) increasing earnings or (2) reducing capital employed. Therefore, underutilized assets tend to be flushed out and disposed of.
Introduction of residual income measures often leads to surprising reductions in assets employed—not from one or two big capital disinvestment decisions, but from many small ones. Ehrbar quotes a sewing machine operator at Herman Miller Corporation:
[EVA] lets you realize that even assets have a cost. . . . We used to have these stacks of fabric sitting here on the tables until we needed them. . . . We were going to use the fabric anyway, so who cares that we’re buying it and stacking it up there? Now no one has excess fabric. They only have the stuff we’re working on today. And it’s changed the way we connect with suppliers, and we’re having [them] deliver fabric more often.25
If you propose to tie a manager’s remuneration to her business’s profitability, it is clearly better to use EVA than accounting income, which takes no account of the cost of the capital employed. But what are the limitations of EVA? Here we return to the same question that bedevils stock-based measures of performance. How can you judge whether a low EVA is a consequence of bad management or of factors outside the manager’s control? The deeper you go in the organization, the less independence that managers have and therefore the greater the problem in measuring their contribution.
The second limitation with any accounting measure of performance lies in the data on which it is based. We explore this issue in the next section.
12-5Biases in Accounting Measures of Performance
Anyone using accounting measures of performance had better hope that the accounting numbers are accurate. Unfortunately, they are often not accurate, but biased. Applying EVA or any other accounting measure of performance therefore requires adjustments to the income statements and balance sheets.
For example, think of the difficulties in measuring the profitability of a pharmaceutical research program, where it typically takes 10 to 12 years to bring a new drug from discovery to final regulatory approval and the drug’s first revenues. That means 10 to 12 years of guaranteed losses, even if the managers in charge do everything right. Similar problems occur in start-up ventures, where there may be heavy capital outlays but low or negative earnings in the first years of operation. This does not imply negative NPV, so long as operating earnings and cash flows are sufficiently high later on. But EVA and ROI would be negative in the start-up years, even if the project were on track to a strong positive NPV.
The problem in these cases is not with EVA or ROI, but with the accounting data. The pharmaceutical R&D program may be showing accounting losses because generally accepted accounting principles require that outlays for R&D be written off as current expenses. But from an economic point of view, those outlays are an investment, not an expense. If a proposal for a new business predicts accounting losses during a start-up period, but the proposal nevertheless shows a positive NPV, then the start-up losses are really an investment—cash outlays made to generate larger cash inflows when the business hits its stride.
Example: Measuring the Profitability of the Nodhead Supermarket
Supermarket chains invest heavily in building and equipping new stores. The regional manager of a chain is about to propose investing $1 million in a new store in Nodhead. Projected cash flows are
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Of course, real supermarkets last more than six years. But these numbers are realistic in one important sense: It may take two or three years for a new store to build up a substantial, habitual clientele. Thus, cash flow is low for the first few years even in the best locations.
We will assume the opportunity cost of capital is 10%. The Nodhead store’s NPV at 10% is zero. It is an acceptable project, but not an unusually good one:
With NPV = 0, the true (internal) rate of return of this cash-flow stream is also 10%.
Table 12.2 shows the store’s forecasted book profitability, assuming straight-line depreciation over its six-year life. The book ROI is lower than the true return for the first two years and higher afterward.26 EVA also starts negative for the first two years, then turns positive and grows steadily to year 6. These are typical outcomes, because accounting income is too low when a project or business is young and too high as it matures.
TABLE 12.2 Forecasted book income, ROI, and EVA for the proposed Nodhead store. Book ROI and EVA are underestimated for the first two years and overestimated thereafter.
Note: There are minor rounding errors in some annual figures.
At this point the regional manager steps up on stage for the following soliloquy:
The Nodhead store’s a decent investment. But if we go ahead, I won’t look very good at next year’s performance review. And what if I also go ahead with the new stores in Russet, Gravenstein, and Sheepnose? Their cash-flow patterns are pretty much the same. I could actually appear to lose money next year. The stores I’ve got won’t earn enough to cover the initial losses on four new ones.
Of course, everyone knows new supermarkets lose money at first. The loss would be in the budget. My boss will understand—I think. But what about her boss? What if the board of directors starts asking pointed questions about profitability in my region? I’m under a lot of pressure to generate better earnings. Pamela Quince, the upstate manager, got a bonus for generating a positive EVA. She didn’t spend much on expansion.
The regional manager is getting conflicting signals. On the one hand, he is told to find and propose good investment projects. Good is defined by discounted cash flow. On the other hand, he is also urged to seek high book income. But the two goals conflict because book income does not measure true income. The greater the pressure for immediate book profits, the more the regional manager is tempted to forgo good investments or to favor quick payback projects over longer-lived projects, even if the latter have higher NPVs.
Measuring Economic Profitability
Let us think for a moment about how profitability should be measured in principle. It is easy enough to compute the true, or economic, rate of return for a common stock that is continuously traded. We just record cash receipts (dividends) for the year, add the change in price over the year, and divide by the beginning price:
The numerator of the expression for rate of return (cash flow plus change in value) is called economic income:
Economic income = cash flow + change in present value
Any reduction in present value represents economic depreciation; any increase in present value represents negative economic depreciation. Therefore,
Economic income = cash flow − economic depreciation
The concept works for any asset. Rate of return equals cash flow plus change in value divided by starting value:
where PV0 and PV1 indicate the present values of the business at the ends of years 0 and 1.
The only hard part in measuring economic income is calculating present value. 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.
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. (In fact, it is not clear that accountants should even try to measure true profitability. They could not do so without heavy reliance on subjective estimates of value. Perhaps they should stick to supplying objective information and leave the estimation of value to managers and investors.)
It is not hard to forecast economic income and rate of return for the Nodhead store. Table 12.3 shows the calculations. From the cash-flow forecasts we can forecast present value at the start of periods 1 to 6. Cash flow minus economic depreciation equals economic income. Rate of return equals economic income divided by start-of-period value.
TABLE 12.3 Forecasted economic income, rate of return, and EVA for the proposed Nodhead store. Economic income equals cash flow minus economic depreciation. Rate of return equals economic income divided by value at start of year. EVA equals income minus cost of capital times value at start of year.
Note: There are minor rounding errors in some annual figures.
Of course, these are forecasts. Actual future cash flows and values will be higher or lower. Table 12.3 shows that investors expect to earn 10% in each year of the store’s six-year life. In other words, investors expect to earn the opportunity cost of capital each year from holding this asset.
Notice that EVA calculated using present value and economic income is zero in each year of the Nodhead project’s life. For year 2, for example,
EVA = 100 − (.10 × 1,000) = 0
EVA should be zero, because the project’s true rate of return is only equal to the cost of capital. EVA will always give the right signal if, and only if, book income equals economic income and asset values are measured accurately.
Do the Biases Wash Out in the Long Run?
Even if the forecasts for the Nodhead store turn out to be correct, ROI and EVA will be biased if they are based on book income and book value. That might not be a serious problem if the errors wash out in the long run, when the region settles down to a steady state with an even mix of old and new stores.
It turns out that the errors do not wash out in the steady state. Table 12.4 shows steady-state book ROIs and EVAs for the supermarket chain if it opens one store a year. For simplicity, we assume that the company starts from scratch and that each store’s cash flows are carbon copies of the Nodhead store. The true rate of return on each store is, therefore, 10% and the true EVA is zero. But as Table 12.4 demonstrates, steady-state book ROI and estimated EVA overstate the true profitability.
TABLE 12.4 Book ROI for a group of stores like the Nodhead store. The steady-state book ROI overstates the 10% economic rate of return. The steady-state EVA is also biased upward.
Note: There are minor rounding errors in some annual figures.
a Book income = cash flow − book depreciation.
b Steady-state book ROI.
c Steady-state EVA.
Thus, we still have a problem even in the long run. The extent of the error depends on how fast the business grows. We have just considered one steady state with a zero growth rate. Think of another firm with a 5% steady-state growth rate. Such a firm would invest $1,000 the first year, $1,050 the second, $1,102.50 the third, and so on. Clearly, the faster growth means more new projects relative to old ones. The greater weight given to young projects, which have low book ROIs and negative apparent EVAs, the lower the business’s apparent profitability.27
What Can We Do about Biases in Accounting Profitability Measures?
The dangers in judging profitability by accounting measures are clear from these examples. To be forewarned is to be forearmed. But we can say something beyond just “be careful.”
It is natural for firms to set a standard of profitability for plants or divisions. Ideally, that standard should be the opportunity cost of capital for investment in the plant or division. That is the whole point of EVA: to compare actual profits with the cost of capital. But if performance is measured by return on investment or EVA, then these measures need to recognize accounting biases. Ideally, the financial manager should identify and eliminate accounting biases before calculating EVA or net ROI. The managers and consultants that implement these measures work hard to adjust book income closer to economic income. For example, they may record R&D as an investment rather than an expense and construct alternative balance sheets showing R&D as an asset.
Accounting biases are notoriously hard to get rid of, however. Thus, many firms end up asking not “Did the widget division earn more than its cost of capital last year?” but “Was the widget division’s book ROI typical of a successful firm in the widget industry?” The underlying assumptions are that (1) similar accounting procedures are used by other widget manufacturers and (2) successful widget companies earn their cost of capital.
There are some simple accounting changes that could reduce biases in performance measures. Remember that the biases all stem from not using economic depreciation. Therefore, why not switch to economic depreciation? The main reason is that each asset’s present value would have to be reestimated every year. Imagine the confusion if this were attempted. You can understand why accountants set up a depreciation schedule when an investment is made and then stick to it. But why restrict the choice of depreciation schedules to the old standbys, such as straight-line? Why not specify a depreciation pattern that at least matches expected economic depreciation? For example, the Nodhead store could be depreciated according to the expected economic depreciation schedule shown in Table 12.3. This would avoid any systematic biases. It would break no law or accounting standard. This step seems so simple and effective that we are at a loss to explain why firms have not adopted it.28
SUMMARY
In an ideal world, managers would make all positive-NPV investments and only positive-NPV investments.29 But managers are not perfect servants of shareholders. Agency costs are incurred when they do not maximize shareholder value.
Managers may be tempted to slack off or to consume wasteful perks. They may expand in pursuit of prestige and other private benefits. They may favor entrenching investments that reinforce their personal value to the firm. They may overinvest, especially when cash flow is plentiful. They may resist disinvestment even when shrinking adds value.
Of course, managers who are tempted do not automatically give in. They recognize their responsibilities. They want their companies to be efficient and competitive. But they also know they are monitored, not just by shareholders and the board of directors, but also by auditors, regulators, and banks and other lenders. Compensation packages are also designed to align managers’ and shareholders’ interests.
Compensation for top management typically includes grants of stock, stock options, or bonuses based on stock-price performance. Thus, managers have strong incentives to increase shareholder value. Compensation tied to stock price is not a perfect solution to agency problems, however. It forces managers to bear market or macroeconomic risks that they cannot control. It may also encourage short-termism—that is, an excessive focus on short-term results at the expense of long-term investment. It appears that U.S. CEOs and CFOs are willing to sacrifice long-term value (e.g., by cutting back R&D) in order to make sure that earnings per share look good to investors.
The further you go down a company’s organization chart, the more tenuous the link between stock price and a manager’s effort and decisions. Therefore, a higher fraction of pay depends on accounting income. But increasing accounting income is not the same thing as increasing value. Accountants do not recognize the cost of capital as an expense. Many companies now tie compensation to economic value added (EVA) or other measures of residual income. These measures start with accounting income but subtract a charge for capital employed. This charge pushes managers and other employees to let go of unneeded assets and to acquire new ones only when the additional earnings exceed the cost of capital.
The usefulness of EVA or other residual income measures depends on accurate measures of income and capital employed. Adjustments to accounting data may be needed to make sure the measures are not misleading.
In principle, companies should use true or economic income instead of accounting income. Economic income equals the cash flow less economic depreciation (i.e., the decline in the present value of the asset). Unfortunately, we can’t ask accountants to recalculate each asset’s present value each time income is calculated. But it does seem fair to ask why they don’t at least try to match book depreciation schedules to typical patterns of economic depreciation.
The more pressing problem is that CEOs and CFOs seem to pay too much attention to earnings, at least in the short run, to maintain smooth growth and to meet earnings targets. They manage earnings, not with improper accounting, but by tweaking operating and investment plans. For example, they may defer a positive-NPV project for a few months to move the project’s up-front expenses into the next fiscal year. It’s not clear how much value is lost by this kind of behavior, but any value loss is unfortunate.
FURTHER READING
Current practices in management remuneration are discussed in:
A. Edmans, X. Gabaix, and D. Jenter, “Executive Compensation: A Survey of Theory and Evidence,” European Corporate Governance Institute, June 26, 2017.
R. K. Aggarwal, “Executive Compensation and Incentives,” in B. E. Eckbo (ed.), Handbook of Empirical Corporate Finance (Amsterdam: Elsevier/North-Holland, 2007), Chapter 7.
R. Rau, “Executive Compensation,” Foundations and Trends in Finance 10 (2017), pp. 181–362.
The following surveys argue that executive compensation has been excessive, owing partly to weaknesses in corporate governance:
L. Bebchuk and J. Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation (Cambridge, MA: Harvard University Press, 2005).
M. C. Jensen, K. J. Murphy, and E. G. Wruck, “Remuneration: Where We’ve Been, How We Got to Here, What Are the Problems, and How to Fix Them,” 2004, at www.ssrn.com, posted July 12, 2004.
The Fall 2005 issue of the Journal of Applied Corporate Finance focuses on executive pay and corporate governance.
The following article is worth reading for survey evidence on earnings and corporate reporting:
J. R. Graham, C. R. Harvey, and S. Rajgopal, “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics 40 (2005), pp. 3–73.
For easy-to-read descriptions of EVA, see:
G. Bennett Stewart III, Best Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value (New York: John Wiley & Sons, 2013).
J. M. Stern and J. S. Shiely, The EVA Challenge—Implementing Value-Added Change in an Organization (New York: John Wiley & Sons, 2007).
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Terminology* Define the following:
a. Agency costs in capital investment.
b. Private benefits.
c. Empire building.
d. Entrenching investment.
e. Delegated monitoring.
2. Monitoring Monitoring alone can never completely eliminate agency costs in capital investment. Briefly explain why.
3. Monitoring Who monitors the top management of public U.S. corporations? (We have mentioned several types of monitoring in this chapter.)
4. Management compensation* True or false?
a. U.S. CEOs are paid much more than CEOs in other countries.
b. A large fraction of compensation for U.S. CEOs comes from grants of restricted shares or performance shares.
c. Stock-option grants give the manager a certain number of shares delivered at annual intervals, usually over five years.
d. U.S. accounting rules now require recognition of the value of stock-option grants as a compensation expense.
5. Management compensation Compare typical compensation and incentive arrangements for (a) top management (e.g., the CEO or CFO) and (b) plant or division managers. What are the chief differences? Can you explain them?
6. Management compensation Suppose all plant and division managers were paid only a fixed salary—no other incentives or bonuses.
a. Describe the agency problems that would appear in capital investment decisions.
b. How would tying the managers’ compensation to EVA alleviate these problems?
7. Management compensation We noted that management compensation must, in practice, rely on results rather than on effort. Why? What problems are introduced by not rewarding effort?
8. Management compensation Here are a few questions about compensation schemes that tie top management’s compensation to the rate of return earned on the company’s common stock.
a. Today’s stock price depends on investors’ expectations of future performance. What problems does this create?
b. Stock returns depend on factors outside the managers’ control—for example, changes in interest rates or prices of raw materials. Could this be a serious problem? If so, can you suggest a partial solution?
c. Compensation schemes that depend on stock returns do not depend on accounting data. Is that an advantage? Why or why not?
9. Management compensation You chair the compensation committee of the board of directors of Androscoggin Copper. A consultant suggests two stock-option packages for the CEO:
a. A conventional stock-option plan, with the exercise price fixed at today’s stock price.
b. An alternative plan in which the exercise price depends on the future market value of a portfolio of the stocks of other copper-mining companies. This plan pays off for the CEO only if Androscoggin’s stock price performs better than its competitors’. The second plan sets a higher hurdle for the CEO, so the number of shares should be higher than in the conventional plan.
Assume that the number of shares granted under each plan has been calibrated so that the present values of the two plans are the same. Which plan would you vote for? Explain.
10. Management compensation In recent years, several large banks have paid management bonuses partly in bonds and partly in stock. What do you think is the reason for this? Do you think it is a good idea?
11. Earnings targets How, in practice, do managers of public firms meet short-run earnings targets? By creative accounting?
12. Economic income Fill in the blanks: “A project’s economic income for a given year equals the project’s _____ less its_____depreciation. New projects may take several years to reach full profitability. In these cases, book income is_____than economic income early in the project’s life and_____than economic income later in its life.”
13. Economic income* Consider the following project:
The internal rate of return is 20%. The NPV, assuming a 20% opportunity cost of capital, is exactly zero. Calculate the expected economic income and economic depreciation in each year.
14. Accounting measures of performance Use the Beyond the Page feature to access the Excel program for measuring the profitability of the Nodhead project. Reconstruct Table 12.4 assuming a steady-state growth rate of 10% per year. Your answer will illustrate a fascinating theorem—namely, that book rate of return equals the economic rate of return when the economic rate of return and the steady-state growth rate are the same.
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15. Accounting measures of performance* The Modern Language Corporation earned $1.6 million on net assets of $20 million. The cost of capital is 11.5%. Calculate the net ROI and EVA.
16. Accounting measures of performance Calculate the year-by-year book and economic profitability for investment in polyzone production, as described in Chapter 11. Use the cash flows and competitive spreads shown in Table 11.2, and assume straight-line depreciation over 10 years. What is the steady-state book rate of return (ROI) for a mature company producing polyzone? Assume no growth and competitive spreads.
17. Accounting measures of performance True or false? Explain briefly.
a. Book profitability measures are biased measures of true profitability for individual assets. However, these biases “wash out” when firms hold a balanced mix of old and new assets.
b. Systematic biases in book profitability would be avoided if companies used depreciation schedules that matched expected economic depreciation. However, few, if any, firms have done this.
18. EVA Here are several questions about economic value added or EVA.
a. Is EVA expressed as a percentage or a dollar amount?
b. Write down the formula for calculating EVA.
c. What is the difference, if any, between EVA and residual income?
d. What is the point of EVA? Why do firms use it?
e. Does the effectiveness of EVA depend on accurate measures of accounting income and assets?
19. EVA* Herbal Resources is a small but profitable producer of dietary supplements for pets. This is not a high-tech business, but Herbal’s earnings have averaged around $1.2 million after tax, largely on the strength of its patented enzyme for making cats nonallergenic. The patent has eight years to run, and Herbal has been offered $4 million for the patent rights. Herbal’s assets include $2 million of working capital and $8 million of property, plant, and equipment. The patent is not shown on Herbal’s books. Suppose Herbal’s cost of capital is 15%. What is its EVA?
20. EVA Table 12.5 shows a condensed income statement and balance sheet for Androscoggin Copper’s Rumford smelting plant.
a. Calculate the plant’s EVA. Assume the cost of capital is 9%.
b. As Table 12.5 shows, the plant is carried on Androscoggin’s books at $48.32 million. However, it is a modern design, and could be sold to another copper company for $95 million (including net working capital). How should this fact change your calculation of EVA?
|
Income Statement for 2018 |
Assets, December 31, 2018 |
||
|
Revenue |
$56.66 |
Net working capital |
$ 7.08 |
|
Raw materials cost |
18.72 |
||
|
Operating cost |
21.09 |
Investment in plant and equipment |
69.33 |
|
Depreciation |
4.50 |
Less accumulated depreciation |
21.01 |
|
Pretax income |
$12.35 |
Net plant and equipment |
$48.32 |
|
Tax at 21% |
2.59 |
||
|
Net income |
$ 9.76 |
Total assets |
$55.40 |
TABLE 12.5 Condensed financial statements for the Rumford smelting plant. See Problem 20 (figures in $ millions).
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21. EVA Use the Beyond the Page feature to access the Excel program for calculating the profitability of the Nodhead project. Now suppose that the cash flows from Nodhead’s new supermarket are as follows:
a. Recalculate economic depreciation. Is it accelerated or decelerated?
b. Rework Tables 12.2 and 12.3 to show the relationship between (a) the “true” rate of return and book ROI and (b) true EVA and forecasted EVA in each year of the project’s life.
22. EVA Ohio Building Products (OBP) is considering the launch of a new product that would require an initial investment in equipment of $30,800 (no investment in working capital is required). The forecast profits from the product are as follows:
|
Year 1 |
Year 2 |
|
|
Net revenues |
$23,337 |
$22,152 |
|
Depreciation |
13,860 |
16,940 |
|
Pretax profit |
9,477 |
5,212 |
|
Tax at 21% |
3,317 |
1,824 |
|
Net profit |
$6,160 |
$3,388 |
23. No cash flows are forecast after year 2, and the equipment will have no salvage value. The cost of capital is 10%.
a. What is the project’s NPV?
b. Calculate the expected EVA and the return on investment in each of years 1 and 2.
c. Why does EVA decline between years 1 and 2, whereas the return on investment is unchanged?
d. Calculate the present value of the economic value added. How does this figure compare with the project NPV?
e. What would be the return on investment and EVA if OBP chooses instead to depreciate the investment straight line? Do you think that this would provide a better standard for measuring subsequent performance?
CHALLENGE
23. Accounting measures of performance Consider an asset with the following cash flows:
The firm uses straight-line depreciation. Thus, for this project, it writes off $4 million per year in years 1, 2, and 3. The discount rate is 10%.
a. Show that economic depreciation equals book depreciation.
b. Show that the book rate of return is the same in each year.
c. Show that the project’s book profitability is its true profitability.
d. You’ve just illustrated another interesting theorem. If the book rate of return is the same in each year of a project’s life, the book rate of return equals the IRR.
24. Accounting measures of performance In our Nodhead example, true depreciation was decelerated. That is not always the case. For instance, Table 12.6 shows how, on average, the market value of a Boeing 737 has varied with its age30 and the cash flow needed in each year to provide a 10% return. (For example, if you bought a 737 for $19.69 million at the start of year 1 and sold it a year later, your total profit would be 17.99 + 3.67 − 19.69 = $1.97 million, 10% of the purchase cost.)
Many airlines write off their aircraft straight-line over 15 years to a salvage value equal to 20% of the original cost.
a. Calculate economic and book depreciation for each year of the plane’s life.
b. Compare the true and book rates of return in each year.
c. Suppose an airline invested in a fixed number of Boeing 737s each year. Would steady-state book return overstate or understate true return?
|
Start of Year |
Market Value |
Cash Flow |
|
1 |
19.69 |
|
|
2 |
17.99 |
$3.67 |
|
3 |
16.79 |
3.00 |
|
4 |
15.78 |
2.69 |
|
5 |
14.89 |
2.47 |
|
6 |
14.09 |
2.29 |
|
7 |
13.36 |
2.14 |
|
8 |
12.68 |
2.02 |
|
9 |
12.05 |
1.90 |
|
10 |
11.46 |
1.80 |
|
11 |
10.91 |
1.70 |
|
12 |
10.39 |
1.61 |
|
13 |
9.91 |
1.52 |
|
14 |
9.44 |
1.46 |
|
15 |
9.01 |
1.37 |
|
16 |
8.59 |
1.32 |
TABLE 12.6 Estimated market values of a Boeing 737 in January 1987 as a function of age, plus the cash flows needed to provide a 10% true rate of return (figures in $ millions)
1Rajan and Wulf argue that it is wrong to treat all perks as managerial excess. That corporate jet can be an excellent investment if it saves several hours a week that the CEO or CFO would otherwise waste in airports. Also, some large companies require the CEO to fly in the corporate jet for security reasons. See R. Rajan and J. Wulf, “Are Perks Purely Managerial Excess?” Journal of Financial Economics 79 (January 2006), pp. 1–33.
2A. Shleifer and R. W. Vishny, “Management Entrenchment: The Case of Manager-Specific Investments,” Journal of Financial Economics 25 (November 1989), pp. 123–140.
3M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76 (May 1986), pp. 323–329.
4S. Mullainathan and M. Bertrand, “Do Managers Prefer a Quiet Life? Corporate Governance and Managerial Preferences,” Journal of Political Economy 111 (2003), pp. 1043–1075. When corporations are better protected from takeovers, wages increase, fewer new plants are built, and fewer old plants are shut down. Productivity and profitability also decline.
5Kelly Shue and Richard Townsend find that increases in CEOs’ option awards were followed, on average, by increases in the volatility of their companies’ stocks. It appears that the additional volatility was caused by higher financial leverage—that is, increased use of debt vs. equity financing. Chapter 17 explains how financial leverage increases volatility. See K. Shue and R. Townsend, “How Do Quasi-Random Option Grants Affect CEO Risk-Taking?”, Journal of Finance 72 (December 2017), pp. 2551–2588.
6Baring Brothers, a British bank with a 200-year history, was wiped out when one of its traders, Nick Leeson, lost $1.4 billion trading in Japanese stock market indexes from a Barings office in Singapore. Leeson was gambling for redemption. As his losses mounted, he kept doubling and redoubling his trading bets in an attempt to recover his losses.
7See Spencer Stuart Board Index, www.spencerstuart.com/research-and-insight/spencer-stuart-board-index-2016.
8The interests of lenders and shareholders are not always aligned—see Chapter 18. But a company’s ability to satisfy lenders is normally good news for stockholders, particularly when lenders are well placed to monitor.
9A. Brav, W. Jiang, F. Partnoy, and R. Thomas, “Hedge Fund Activism, Corporate Governance, and Firm Performance,” Journal of Finance 63 (2008), pp. 1729–1775.
10Bizjak, Lemmon, and Naveen found that most firms set pay levels at or above the median of the peer group, and some firms go much higher. For example, Coca-Cola and IBM consistently aim for levels in the top quartile of their peers. See J. M. Bizjak, M. L. Lemmon, and L. Naveen, “Has the Use of Peer Groups Contributed to Higher Pay and Less Efficient Compensation?” Journal of Financial Economics 90 (November 2008), pp. 152–168.
11Other countries that have given shareholders nonbinding votes on compensation include Australia, Sweden, and the U.K. Shareholders in the Netherlands have a binding vote.
12This sharp rise in CEO pay started in the 1970s. For the previous 30 years, pay levels were essentially flat. See C. Frydman and R. Saks, “Executive Compensation: A New View from a Long-Term Perspective, 1936–2005,” Review of Financial Studies 23 (2010), pp. 2099–2138.
13Gabaix and Landier argue that high CEO pay is a natural consequence of steadily increasing firm values and the competition for management talent. See X. Gabaix and A. Landier, “Why Has CEO Pay Increased So Much?” Quarterly Journal of Economics 123 (February 2008), pp. 49–100.
14See S. N. Kaplan and J. D. Rauh, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?” Review of Financial Studies 23 (2010), pp. 1004–1050.
15The major exceptions are in China, Japan, India, and South Korea, where such incentive schemes are still used by a minority of large firms.
16M. Bertrand and S. Mullainathan, “Are CEOS Rewarded for Luck? The Ones without Principals Are,” Quarterly Journal of Economics (August 2001), pp. 901–932.
17Recall from Chapter 4 that the price–earnings ratio equals 1/rE, where rE is the cost of equity, unless the firm has valuable growth opportunities (PVGO). The higher the PVGO, the lower the earnings–price ratio and the higher the price–earnings ratio. Thus, the high price–earnings ratios observed for growth companies (much higher than plausible estimates of 1/ rE) imply that investors forecast large PVGOs. But PVGO depends on investments to be made many years in the future. If investors see significant PVGOs, they cant be systematically short-sighted.
18J. R. Graham, C. R. Harvey, and S. Rajgopal, “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics 40 (2005), pp. 3–73.
19F. Degeorge, J. Patel, and R. Zeckhauser, “Earnings Management to Exceed Thresholds,” The Journal of Business 72 (January 1999), pp. 1–33.
20Sometimes, instead of adjusting their operations, companies meet their target earnings by bending the accounting rules. For example, in August 2009, GE was fined $50 million for creative accounting in earlier years. The SEC said that GE had met or exceeded analysts’ profit targets in every quarter from 1995 through 2004, but that its top accountants signed off on improper decisions to make its numbers look better and to avoid missing analysts’ earnings expectations.
21Graham, Harvey, and Rajgopal, op. cit., p. 29.
22Notice that investment includes the net working capital (current assets minus current liabilities) required to operate the plant. The investment shown is also called net assets or the net capital invested in the plant. We say “ROI,” but you will also hear “return on capital” (ROC). “Return on assets” (ROA) sometimes refers to return on assets defined to include net working capital, as in Table 12.1, but sometimes to return on total assets, where current assets are included but current liabilities are not subtracted. It’s prudent to check definitions when reviewing reported ROIs, ROCs, or ROAs. In Chapter 28, we look more carefully at how these measures are calculated.
23Notice that earnings are calculated after tax but with no deductions for interest paid. The plant is evaluated as if it were all-equity-financed. This is standard practice (see Chapter 6). It helps to separate investment and financing decisions. The tax advantages of debt financing supported by the plant are picked up not in the plant’s earnings or cash flows, but in the discount rate. The cost of capital is the after-tax weighted-average cost of capital, or WACC. WACC was briefly introduced in Chapter 9 and will be further explained in Chapters 17 and 19.
24The term EVA was coined by the consulting firm Stern Stewart, which popularized and implemented this measure of residual income. Stern Stewart’s EVA practice has mostly moved to the follow-on consulting firm EVA Dimensions. EVA is conceptually the same as the residual income measure advocated by some accounting scholars. See R. Anthony, “Accounting for the Cost of Equity,” Harvard Business Review 51 (1973), pp. 81–102; and “Equity Interest—Its Time Has Come,” Journal of Accountancy 154 (1982), pp. 76–93.
25A. Ehrbar, EVA: The Real Key to Creating Wealth (New York: John Wiley & Sons, 1998), pp. 130–131.
26The errors in book ROI always catch up with you in the end. If the firm chooses a depreciation schedule that overstates a project’s return in some years, it must also understate the return in other years. In fact, you can think of a project’s IRR as a kind of average of the book returns. It is not a simple average, however. The weights are the project’s book values discounted at the IRR. See J. A. Kay, “Accountants, Too, Could Be Happy in a Golden Age: The Accountant’s Rate of Profit and the Internal Rate of Return,” Oxford Economic Papers 28 (1976), pp. 447–460.
27We could repeat the steady-state analysis in Table 12.4 for different growth rates. It turns out that book income will overstate economic income if the growth rate is less than the internal rate of return and understate economic income if the growth rate exceeds the internal rate of return. Biases disappear if the growth rate and internal rate of return are exactly equal.
28This procedure has been suggested by several authors; see, for example, Zvi Bodie, “Compound Interest Depreciation in Capital Investment,” Harvard Business Review 60 (May–June 1982), pp. 58–60.
29There are, of course, many types of investments that generate no cash flows directly, but are nevertheless required for safety, efficiency, or to meet legal, regulatory, or ethical standards. Examples include investments for safety and pollution control. Companies make these investments even though they may appear to have negative NPVs.
30We are grateful to Mike Staunton for providing us with these estimates.