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Advanced Corporate Finance FINA 7330 Ronald F. Singer

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:

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Advanced Corporate Finance FINA 7330 Ronald F. Singer

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  1. Advanced Corporate FinanceFINA 7330Ronald F. Singer Agency Problems and Control Lecture 4 Fall, 2010

  2. 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

  3. Conflicts of Interest • Reduced effort on the part of the agent • Excessive perks consumption • Empire building • Entrenchment • Risk avoidance

  4. Agency Problem • How do you resolve these conflicts? • Monitoring • 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

  5. 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

  6. 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

  7. 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

  8. 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.

  9. 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.

  10. 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

  11. 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

  12. 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)

  13. EVA of US firms - 2003 ($ in millions)

  14. Summary of Performance Valuation • 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

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