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19ECB004 - Introduction to Financial Economics > L13 - Agency > Flashcards

Flashcards in L13 - Agency Deck (31)
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1
Q

What is the principal-agent problem?

A
  • Shareholders (principals) = Owners
  • Managers (agents) = Employees
  • Managers have the power to manage day-to-day aspects of the firm.
  • Managers have more information than the shareholders. –> information asymmetry, know about the project and which would be better for them or better for the owners
  • Agency problems occur when managers do not act in the shareholders’ interest.
2
Q

Why does not having any incentives for Financial Managers not solve the principal-agent problem?

A

No system of incentives is perfect…but what won’t work? Shareholders decide to pay the financial managers a fixed salary (no bonuses, no stock options,…) - this will most likely lead to:

  • reduced effort - low incentive to find and invest in truly valuable (+NPV) projects;
  • perks - take nonpecuniary private benefits anyway (company car, lavish office, meetings in luxury resorts,…)
  • empire building - prefer running large business rather than small ones (may not be +NPV). Results in overinvesting.
  • insufficient disinvestment – reluctance to disinvest, e.g. close loss-making business. Results in overinvesting.
  • entrenching investment - choose investments that require or reward the skills of the existing managers. –> rather than picking investments that benefit the firm
  • risk-aversion - try to avoid risk or more risky projects

All these are inefficiencies that reduce the value of the firm.

3
Q

When are managers the principal in the principal-agent problem?

A
  • Top managers are also principals vis-a-vis the rest of the firm (middle managers and other employees who are working for them). as employees objective should aline with management and by extention, as top managers objective aline with shareholders, they also must aline with the owners too
  • Top management must try to ensure that…
    • middle managers and employees have the right incentives to find and invest in +NPV projects.
  • Difficult to get incentives right in a large corporation.
    • different employees with differing levels of responsibility and senority
  • Why not bypass these difficulties, and let the top managers make the important investment decisions?
    • in theory it would be easier as their objective should aline with the owners
4
Q

Why would bypassing incentive and letting top management make the investment decisions not solve the principal-agent problem?

A
  • Too many projects for top management to analyse ⇒ difficult to make intelligent decisions;
  • Details are beyond the view of executives –> location, workers available, cashflow based on these various factors –> managers may not get all these details and may just get profitability calculation and cashflows - would they make the same decision if they had all the appropriate information?? - thus need employees
  • Many decisions/capital investments don’t appear in the capital budget (e.g. : R&D, training, marketing,…) –> might not know these cashflows exist and havent taken them into account when deciding on an investment project
  • Small decisions add up… –> inventory investment build up over time but these are dealt with lower level employees so senior management doesnt deal with this ‘lower-level’ work but its does not mean it isnt important
5
Q

How can Monitoring reduce the Principal-Agent Problem?

A

Monitoring: Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course (shareholders, board of directors, auditors, lenders, takeovers…). –> give them a warning or remove them

But monitoring also involve costs and diminishing returns…

  • you can only monitor what you observe - you dont get any reward for the time and effort spent observing senior managers - its a imperfect solution to the principal-agent problem

How to pay managers in order to reduce the cost and need for monitoring and to maximize shareholder value?

6
Q

how can shareholders monitor management?

A

shareholders (e.g. selling shares because they dont like what they are seeing in documents or the news , doesnt bode well for managers when the share price falls)

large group of shareholders with a large amount of say, could vote to remove the manager - this is done by electing a independent board of directors to oversee the managers

7
Q

How can auditors monitor management?

A

auditors –> look at financial statements to see if they follow generally accept accounting practices –> do not want a bad report as can affect share price

8
Q

How can lenders monitor management?

A

lenders –> looking at cashflows and financial statements to make sure they can meet their debt obligations - if they offer a high interest rate do they not trust your organisation

9
Q

How can other companies monitor management?

A

takeovers –> companies are always monitoring others- if companies are not efficient and management is making poor decisions, others may make takeover bids and replace senior management

10
Q

How can Management Copmensation be used to reduce the Principal-Agent Problem?

A

Because monitoring is imperfect, compensation plans must be designed to attract competent managers and to give them the right incentives. - attracts and keeps them working in the best interest of shareholders

So… the amount of compensation may be less important than how it is structured.

The compensation package should encourage managers to maximize shareholders’ wealth.

11
Q

What should Manager Compensation be based on?

A
  • input (managers’ effort) and
  • output (incomes or value-added from managers’ actions

It is very difficult to monitor the actions (effort) of managers. –M might be there all day but are they being productive

Therefore……compensation should be based on output. –> changes in earnings, profitability and output can be observed easily

12
Q

What is the average Management Compensation across countries?

A
13
Q

How has Management Compensation changed over time?

A
14
Q

How has the Structure of Management Compensation changed over time?

A
  • Basic Salary doesnt provide any incentive so it makes up less and less of a managers total compensation
  • More and more managers are being compensated with stock price performance
    • it was stock options but more recently it is restricted stock
15
Q

How can give Managers stock as a form of compensation help reduce the Principal-Agent Problem?

A
  • Capital markets do monitor managers’ actions through the price mechanism (stock prices reflect performance of a firm).
  • Compensation tied to stock prices (like stock options) do reduce the cost and the need for monitoring.

Most major companies link part of their executive pay to the stock-price performance:

  • stock options - give managers the right, but not the obligation, to buy their company’s shares in the future at a fixed exercise price; - hope their performance increases the stock price
  • restricted stock - stock that must be retained for several yrs; - want to remain in a position that you can benefit from increasing the stock price
  • performance shares - shares awarded only if the company meets an earnings or other target.
16
Q

What is the problem with user stocks as compensation?

A

But compensation via options or restricted stock also has imperfections.

Stock-price performance may depend on events outside of managers’ control:

  • payoffs do not account for stock-price changes relatively to the market or to stock prices of other firms in the same industry –> now look at it relative to the industry and markets to see if it a problem with the manager or the economy in general
  • company’s stock price depends on investors’ expectations of future earnings ( optimism of a new manager drive up prices, rather than the effect of their performance) ⟹ rates of return depend on how well the company performs relative to expectations;
  • incentive plans may tempt managers to withhold bad news or manipulate earnings to pump up stock prices;
  • stock options can encourage excessive risk-taking (gambling for redemption). –> stock price is already low have nothing to lose from gambling to redeem themselves
17
Q

How can Accounting Measures of performance be used to compensate managers?

A

Compensation packages, especially for lower-level managers, also depend on accounting measures (accounting profits, earnings, return on investment).

  • Look at how managers are performing in certain divisions
  • Good for middle/lower level managers
18
Q

What are the advantages of using accounting measures of performance to compensate lower-level manag/ers

A
  • based on absolute performance rather than on performance relative to investors’ expectations;
  • make it possible to measure the performance of junior or lower-level managers whose responsibility extends to only a single division or plant.
19
Q

What is the Problem with using Accounting measures of performance for compensation?

A
  • temptation to pump up short-term profits, leaving longer-run problems to successors;
  • accounting earnings can be biased measures of true profitability; –> training, recruitment, marketing campaigns are seen as expenses rather than investments and lower net profitability
    • use book value/past values doesnt take into account opportunity costs and the time value of money
  • growth in earnings does not necessarily mean that shareholders are better off (i.e., earnings from some projects that do not have +NPV).
20
Q

What Techniques can be be used to overcome the problems in accounting measures of performance?

A
  • Net Return on Investment
  • Economic Value Added (Residual Income).

These two methods judge whether the plants returns are higher than the cost of capital

Take into account cost of capital which is the shortfall of accounting measures of performance

21
Q

How do you calculate Net ROI?

A

ROI = Net (or after tax) Income/Net (depreciated) book value of Assets

Net ROI = ROI - Cost of Capital

  • if positive the investment is adding to shareholder value - positive NPV
22
Q

How do you calculate EVA?

A
  • Residual Income or EVA = net pound return after deducting (a charge for) the cost of capital.

To judge the net contribution to value we need to deduct the cost of capital.

EVA = Residual Income

= Income Earned - Income Required

= Income Earned - (Cost of Capital x Investment)

23
Q

How are Net ROI and EVA related?

A

Net ROI and EVA are focusing on the same question:

ROI =CoC ⟹ NetROI =0 & EVA =0

  • But the Net ROI is a % and ignores the scale of the company (and ROI, itself, ignores the cost of capital).
  • EVA recognizes the amount of capital employed and the number of pounds of additional wealth created.
  • EVA’s message — invest if and only if the increase in earnings is enough to cover the cost of capital.
  • Note: the term EVA has been popularized by the consulting firm
    • Stern-Stewart and is used by many companies to measure and reward managers’ performance,
24
Q

What is Economic Profit?

A

The consulting firm McKinsey & Company uses Economic Profit (EP).

Gives the same result as the EVA (another way to measure residual income).

Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital (r):

EP = (ROI -r ) x Capital Invested

25
Q

What are the advantages of EVA?

A
  • EVA encourages managers and employees to concentrate on increasing value, not just on increasing earnings;
  • Managers are motivated to only invest in projects that earn more than they cost;
  • EVA implies delegated decision making (if you tie managers’ compensation to EVA, you must also give them power over decisions that affect EVA)
  • EVA makes cost of capital visible to managers (accounting income takes no account of the cost of the capital);
  • Leads to a reduction in assets/capital employed.
26
Q

Why are the disadvantages of EVA?

A
  • Difficult to judge whether a low EVA is a consequence of bad management or of factors outside the manager’s control
  • EVA does not measure present value (EVA and ROI can be negative in the start-up years, even if the project were on track to a strong positive NPV);
27
Q

How do you calculate Economic Rate of Return?

A
28
Q

What is the problem with measuring Economic Income?

A

The problem 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.
29
Q

How do you calculate Book Value?

A

Accountants rarely even attempt to measure PV

Instead they gvie us book value (BV)

BV = original cost- book depreciation

Book depreciation depends on the companies rules - straight line method, reducing balance method

  • use As book depreciation and economic depreciation are usually different, then book earnings will not measure true earnings
30
Q

What is the summary of the differences between Economic and Accounting measures?

A

As book depreciation and economic depreciation are usually different, then book earnings will not measure true earnings.

  • Depreciation for accountants is based on the method they use and how they class the capitals

True rate of return is based on Economic Depreciation

31
Q

What is the overall problem with Accounting Measures?

A
  • Accounting measures are distorted due to use of book values.
  • Book RoR gives a distorted view of the firm’s performance.
  • Book depreciation is an arbitrary method used by accountants that has no bearing on the change in value of the assets.
  • These biases do not work-out in the long run!