Advanced Corporate Finance
FINA 7330
Ronald F. Singer
Agency Problems and Control
Lecture 4
Fall, 2010
Agency Problem
• The Principal-Agent Relationship
Typically in a Corporation, there are what is called agents and
principals:
The Agent is the “person that acts,” whereas the Principal is
the person that receives the benefits from the actions.
Typical Principal/Agent relationships:
• The Agency Problem tries to solve the natural conflict of
interest that arises as a result of this principal agent
problem
Conflicts of Interest
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Reduced effort on the part of the agent
Excessive perks consumption
Empire building
Entrenchment
Risk avoidance
Agency Problem
• How do you resolve these conflicts?
– Monitoring
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Stockholders
Bondholders
Board of Directors
Financial Press
SEC and other government regulators
Outside auditors
– Issues opinion regarding whether reports are consistent with
generally accepted accounting standards
– Qualified or unqualified opinion
Agency Problem
– Incentives
• Provide a compensation package to managers
that try to induce them to act in stockholders’
interest
• Can’t determine this directly
–Difficult to separate effort from luck
• Usually this is performance (or value) based
incentives
–Stock options
Agency Problem
• Problems with value based compensation
– Difficult to distinguish between effort and
competence, versus luck
– Could be subject to manipulation
• Enron, Fannie Mae,
• Stock options backdating scandal
– Compensation determined by Board
• Sarbanes Oxley: SOX: Compensation Committee must
be independent directors
Agency Problem
• The Basic problem is how do you measure
performance, and how do you get information
that is unbiased?
• You get what you measure
Incentive Issues
• Monitoring - Reviewing the actions of managers and
providing incentives to maximize shareholder value.
• Free Rider Problem - When owners rely on the
efforts of others to monitor the company.
• Management Compensation - How to pay managers
so as to reduce the cost and need for monitoring and
to maximize shareholder value.
Residual Income & EVA
• Emphasizes NPV concepts in performance
evaluation over accounting standards.
• Looks more to long term than short term
decisions.
• More closely tracks shareholder value than
accounting measurements.
Performance Evaluation
• How do you know if management is doing a
good job or not:
• What you measure is what you get
• Must consider tradeoffs of high early return
versus growth
• You want to capture the economic value of
investment not book values
Message of EVA
+ Advantages
Managers are motivated to only invest in
projects that earn more than they cost.
EVA makes cost of capital visible to managers.
Leads to a reduction in assets employed.
Present Value of EVA measures NPV and thus
consistent rewarding via EVA leads to good
decisions
- Disavantages
EVA does not directly measure present value
Rewards quick paybacks and ignores time value of
money
What is Economic Value Added (EVA)
EVA = Residual Income = Income earned –
Income required
= Income earned – Cost of Capital X Capital Invested
Note: Earned income can be written as:
ROI X Book Value of Capital
Income required can be written as:
CoC X Book Value of Capital
SO:
= (ROI – CoC) X BV of Capital
(see spreadsheet)
EVA of US firms - 2003
($ in millions)
Wal-Mart Stores
Johnson & Johnson
Microsoft
Merck
Coca Cola
Intel Corp.
Dow Chemical
Boeing
Delta Airlines
Viacom
IBM
Correlation
Econimic Value
Capital Return on
Added (EVA)
Invested
Capital
4,525
79,177 12.30%
4,459
51,508
17.6
4,027
24,677
29.8
3,347
40,941
16.9
2,729
20,503
20.1
(57)
31,216
15.6
(1,503)
44,158
3.6
(1,974)
50,046
2.2
(2,288)
27,238
-0.9
(5,508)
96,515
3.5
(7,505)
108,926
4.6
0.97
0.51
Cost of NPV of
Capital Cash Flow
6.60%
8.9
13.5
8.7
6.7
15.8
7
6.1
7.5
9.2
11.5
68,380
50,351
29,795
38,588
41,006
(395)
(21,448)
(31,997)
(30,507)
(59,797)
(65,356)
Summary of Performance Valuation
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Use EVA Measure
Use Economic Depreciation
Estimate Cash Flows
Estimate Economic Depreciation from above
Find EVA using existing Economic Depreciation
estimates
• Then value performance on that basis