Management Compensation
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Completing Lecture 20
Student Presentations
Capital Investment Process
Need for Good Information
Incentives
Stock Options
Measuring and Rewarding Performance
Economic Value Added ®
Biases in Accounting Measures
WACC vs. Flow to Equity
– If you discount at WACC, cash flows have to be
projected just as you would for a capital
investment project. Do not deduct interest.
Calculate taxes as if the company were all-equity
financed. The value of interest tax shields is picked
up in the WACC formula.
WACC vs. Flow to Equity
– The company's cash flows will probably not be forecasted
to infinity. Financial managers usually forecast to a
medium-term horizon -- ten years, say -- and add a
terminal value to the cash flows in the horizon year. The
terminal value is the present value at the horizon of posthorizon flows. Estimating the terminal value requires
careful attention, because it often accounts for the
majority of the value of the company.
WACC vs. Flow to Equity
– Discounting at WACC values the assets and
operations of the company. If the object is to value
the company's equity, don't forget to subtract the
value of the company's outstanding debt.
Using WACC in Practice
• Multiple sources of financing
– Weighted average of each element
• Short term debt
– Generally can be ignored
• Other current liabilities
• Costs of financing
– Return on equity can be derived from market data
– Cost of debt is set by the market given the specific rating of a firm’s debt
– Preferred stock often has a preset dividend rate
WACC & Debt Ratios
Example continued: Sangria and the Perpetual Crusher
project at 20% D/V
Step 1 – r at current debt of 40%
r  .06(.4)  .124(.6)  .0984
Step 2 – D/V changes to 20%
rE  .0984  (.0984  .06)(.25)  .108
Note the debt-equity ratio is .2/.8 = .25
Step 3 – New WACC
WACC  .06(1  .35)(. 2)  .108(.8)  .0942
Adjusted Present Value
APV = Base Case NPV
+ PV Impact
• Base Case = All equity finance firm NPV
• PV Impact = all costs/benefits directly
resulting from project
Adjusted Present Value
Example:
Project A has an NPV of $150,000. In order to
finance the project we must issue stock, with a
brokerage cost of $200,000.
Adjusted Present Value
Example:
Project A has an NPV of $150,000. In order to
finance the project we must issue stock, with a
brokerage cost of $200,000.
Project NPV =
150,000
Stock issue cost = -200,000
Adjusted NPV
- 50,000
Don’t do the project
Adjusted Present Value
Example:
Project B has a NPV of -$20,000. We can
issue debt at 8% to finance the project. The
new debt has a PV Tax Shield of $60,000.
Assume that Project B is your only option.
Adjusted Present Value
Example:
Project B has a NPV of -$20,000. We can issue debt
at 8% to finance the project. The new debt has a PV
Tax Shield of $60,000. Assume that Project B is your
only option.
Project NPV =
- 20,000
Stock issue cost = 60,000
Adjusted NPV
40,000
Do the project
Adjusted Present Value
Example – Rio Corporation APV
10 Free cash flow (7+4-8-9)
PV Free cash flow, years 1-6
Pv Horizon value
Base-case PV of company
Debt
PV Interest tax shields
APV
Tax rate, percent
Opportunity cost of capital
WACC (To discount horizon
value to year 6)
Lomg term growth forecast
Interest rate (years 1-6)
After tax debt service
Latest year
0
2.5
1
3.5
2
3.2
50
3.06
1.07
49
3
1.05
2.99
2.95
Forecast
3
3.4
4
5.9
5
6.1
6
6
48
2.94
1.03
47
2.88
1.01
46
2.82
0.99
45
2.76
0.97
2.91
2.87
2.83
2.79
19.7
64.6
84.3
51
5
89.3
35%
9.84%
9%
3%
6%
7
6.8
Adjusted Present Value
Example – Rio Corporation APV - continued
The MFC corporation needs to raise $200 million for its
mega project. The NPV of the project using all equity
financing is $40 million. If the cost of raising funds for
the project is $10 million, what is the APV of the project?
A) $30 million.
B) $40 million.
C) $160 million.
D) $210 million
E) None of the above
Capital Investment Process
• Capital budgeting
– Bottom-up
• Strategic planning
– Top-down
• Project authorizations
• Investments missing from capital budget
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Information technology (IT)
Research and development
Marketing
Training
• Post audits
– What can be learned for next time
The Need for Good Information
• Consistent forecasts
• Reducing forecast bias
– BMA Second Law “The proportion of proposed
projects having a positive NPV at the official
corporate hurdle rate is independent of the hurdle
rate.”
• Eliminating conflicts of interest
Incentives
• Agency problems in capital budgeting
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Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
• Ways to reduce agency costs
– Monitoring
– Incentives
Monitoring Management of a
Public Corporation
• Stockholders
– Small stockholders
– Large investors
• Individuals
• Pension fund
• Mutual fund
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Board of directors
Auditors
Lenders
Rating agencies
Incentives
• Management compensation
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Basic
Bonus
Benefits
Perks
Options
• CEO compensation relative to other employees
– US
– Internationally
Stock Options
• Estimated value in large US corporations
– 1992 $22 million/company
– 2000 $238 million/company
– 2002 $141 million/company
• Accounting choices for stock options
– Consider the fair value of the option as an expense
when the option is granted
– Only deduct the excess of market price over
exercise price (allowed until 2006)
• Options do not create taxable income for
manager until they are exercised
Valuing a Stock Option
• Intrinsic value
• Time value
• Black-Scholes Option Pricing Model
– Reasonable approximation for at the money
options
– Not as good for far in or out of the money options
Black-Scholes Option Pricing Model
C  SN (d 1)  Xe  rt N (d 2)
d 1  [ln( S / X )  (r   2 / 2)t ] / t 1 / 2
d 2  d 1  t 1 / 2
C
S
X
r
t
σ
N
= Price of a call option
= Current price of the asset
= Exercise price
= Risk free interest rate
= Time to expiration of the option
= Volatility of the stock price
= Normal distribution function
Black-Scholes Option Pricing Model
• Values European options on stock
• Assumptions
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No dividends
No taxes or transaction costs
One constant interest rate for borrowing or lending
Unlimited short selling allowed
Continuous markets
Distribution of terminal stock returns is lognormal
• Based on arbitrage portfolio containing stock
and call options
• Required continuous rebalancing
Using the Black-Scholes Model
• Only variables needed
– Underlying stock price
– Exercise price
– Time to expiration
– Volatility of stock price
– Risk-free interest rate
Example
• What is the value of call options on 100,000
shares of stock under the following:
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Current stock price = $20
Exercise price = $20
Time to expiration = 5 years
Standard deviation of stock returns = .25
Risk-free rate = 5%
Value of Each Option
20
2
ln( )  (.05  .5(.25) )5
20
d1 
 .7267
.5
(.25(5) )
d 2  .7267  .25(5)  .1677
.5
C  20 N (.7267)  20e
.05( 5 )
N (.1677)
C  20(.7663)  20(.7788)(. 5666)
C  6.50
Total Value of Option Grant
100,000 x 6.50 = $650,000
• Ways to increase this value even more
– Increase σ
– Reprice the option if stock prices fall
– Drive down the stock price to get a lower
exercise price
– Backdate the option to a time when stock
prices were lower
• Not illegal as long as company expenses it
properly
Measuring and Rewarding Performance
• Companies get the behavior they reward
• Companies reward performance they can
measure
• How to you measure effective performance?
– Accounting profits
– Rates of return
– Growth in earnings
Economic Value Added®
• Economic Value Added (EVA)
– Earnings after deducting the cost of capital
EVA = Residual income
= Income earned – (cost of capital x investment)
• Advantages of EVA
– Makes cost of capital visible to managers
– Better than accounting income as an incentive
• Disadvantages of EVA
– Biased data
A firm has an average investment of $1000 during the
year. During the same time the firm has an after tax
earnings of $150. If the cost of capital is 10%, calculate
the economic value added (EVA) for the firm.
A)
B)
C)
D)
E)
$0
$50
$100
$120
None of the above
Biases in Accounting Measures
• New projects or start-up firms generate
accounting losses the first few years
• Expenses are written off early in the
investment process
• Proposal – measure economic profitability
Next Class
• Thursday, April 17
– Integrating Capital and Risk
– Reading “The Insurative Model” by Prakash Shimpi,
Risk Management August 2001
http://www.rmmag.com/Magazine/PDF/Insurative_Model.pdf