Principles of Corporate Finance Brealey and Myers Sixth Edition Making Sure Managers Maximize NPV Slides by Matthew Will Irwin/McGraw Hill Chapter 12 ©The McGraw-Hill Companies, Inc., 200 12- Topics Covered The capital investment process Decision Makers and Information Incentives Residual Income and EVA Accounting Performance Measures Economic Profit Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- The Principal Agent Problem Shareholders = Owners Question: Who has the power? Answer: Managers Managers = Employees Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- Capital Investment Decision Strategic Planning “Top Down” Capital Investments Project Creation “Bottom Up” Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- Off Budget Expenditures Information Technology Research and Development Marketing Training and Development Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- Information Problems The correct information is … Irwin/McGraw Hill Consistent Forecasts Reducing Forecast Bias Getting Senior Management Needed Information Eliminating Conflicts of Interest ©The McGraw-Hill Companies, Inc., 200 12- Growth and Returns Rate of return, % 12 11 Economic rate of return 10 Book rate of return Irwin/McGraw Hill 10 15 20 25 Rate of growth, % ©The McGraw-Hill Companies, Inc., 200 12- Brealey & Myers Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- Incentives Agency Problems in Capital Budgeting Reduced effort Perks Empire building Entrenching investment Avoiding risk Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 10 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 Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 11 Residual Income & EVA Techniques for overcoming errors in accounting measurements of performance 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 12 Residual Income & EVA Quayle City Subduction Plant ($mil) Income Assets Sales 550 Net W.C COGS 275 Property, plant and equipment 1170 Selling, G&A 75 200 taxes @ 35% Net Income Irwin/McGraw Hill 70 $130 80 less depr 360 Net Invest 810 Other assets 110 Total Assets $1,000 ©The McGraw-Hill Companies, Inc., 200 12- 13 Residual Income & EVA Quayle City Subduction Plant ($mil) 130 ROI = = 13 1,000 Given COC = 10% NetROI = 13% − 10% = 3% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 14 Residual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital EVA = Residual Income = Income Earned - income required = Income Earned - [ Cost of Capital ì Investment] â EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 15 Residual Income & EVA Quayle City Subduction Plant ($mil) Given COC = 12% EVA = Residual Income = 130 − (.12 × 1,000) = +$10million Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 16 Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital EP = Economic Profit = ( ROI − r ) ì Capital Invested â EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 17 Economic Profit Quayle City Subduction Plant ($mil) Example at 12% COC continued EP = ( ROI − r ) × Capital Invested = (.13 - 12) ì 1,000 = $10million â EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 18 Message of EVA + 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 - EVA does not measure present value - Rewards quick paybacks and ignores time value of money Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 19 EVA of US firms - 1997 $ in millions) Capital Return on Cost of Invested Capital Capital Coca Cola $2,442 $10,814 36.0% 9.7% Dow Chemical Ford Motor 6,81 1,719 23,024 58,272 12.2 12.1 9.0 9.1 General Electric 2,515 General Motors - 3,527 Hewlett - Packard - 99 IBM - 2,743 Johnson & Johnson 1,327 53,567 82,887 24,185 67,431 18,138 17.7 5.9 15.2 7.8 21.8 12.7 9.7 15.7 11 13.3 22,219 5,680 42,885 4,963 13,420 30,702 23.0 47.1 20.1 15.7 9.8 11 14.5 11 12.5 8.5 7.2 12.6 Merck Microsoft Philip Morris Safeway UAL Walt Disne y Irwin/McGraw Hill EVA 1,688 1,727 3,119 335 298 - 347 ©The McGraw-Hill Companies, Inc., 200 12- 20 Accounting Measurements cash receipts + change in price Rate of return = beginning price C1 + ( P1 − P0 ) = P0 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 21 Accounting Measurements cash receipts + change in price Rate of return = beginning price C1 + ( P1 − P0 ) = P0 Economic income = cash flow + change in present value C1 + ( PV1 − PV0 ) Rate of return = PV0 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 12- 22 Accounting Measurements INCOME RETURN Irwin/McGraw Hill ECONOMIC ACCOUNTING Cash flow + Cash flow + change in PV = change in book value = Cash flow - Cash flow - economic depreciation accounting depreciation Economic income Accounting income PV at start of year BV at start of year ©The McGraw-Hill Companies, Inc., 200 12- 23 Nodhead Store Forecastes Cash flow PV at start of year (r = 10%) PV at end of year (r = 10%) Change in value Economic income Rate of return % Economic depn Irwin/McGraw Hill YEAR 250 298 901 741 298 517 298 271 100 1000 200 1000 1000 901 741 517 271 0 -99 -160 -224 -246 -271 100 101 90 74 52 27 10 10 10 10 10 10 99 160 224 246 271 ©The McGraw-Hill Companies, Inc., 200 12- 24 Nodhead Book Income & ROI Cash flow BV at start of year, strt line depn BV at end of year, strt line depn Change in BV Book income Book ROI % Book depn Irwin/McGraw Hill 100 1000 200 833 YEAR 250 298 667 500 833 667 500 -167 -67 -6.7 167 -167 +33 4.0 167 333 298 333 298 167 167 -167 -167 -167 -167 +83 +131 +131 +131 12.4 26.2 39.3 78.4 167 167 167 167 ©The McGraw-Hill Companies, Inc., 200 ... Conflicts of Interest ©The McGraw-Hill Companies, Inc., 200 12- Growth and Returns Rate of return, % 12 11 Economic rate of return 10 Book rate of return Irwin/McGraw Hill 10 15 20 25 Rate of growth,... McGraw-Hill Companies, Inc., 200 12- Brealey & Myers Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate Irwin/McGraw... Companies, Inc., 200 12- 16 Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital EP = Economic Profit = ( ROI r ) ì