311 For most large firms, the investment process starts with preparation of an annual capital budget,which is a list of investment projects planned for the coming year.Since the capital
Trang 1M A K I N G S U R E
M A N A G E R S
M A X I M I Z E N P V
Trang 2SO FAR WE’VEconcentrated on criteria and procedures for identifying capital investments with tive NPVs If a firm takes all (and only) positive-NPV projects, it maximizes the firm’s value But do the
posi-firm’s managers want to maximize value?
Managers have no special gene or chromosome that automatically aligns their personal interestswith outside investors’ financial objectives So how do shareholders ensure that top managers do notfeather their own beds or grind their own axes? And how do top managers ensure that middle man-agers and employees try as hard as they can to find positive-NPV projects?
Here we circle back to the principal–agent problems first raised in Chapters 1 and 2 Shareholdersare the ultimate principals; top managers are the stockholders’ agents But middle managers and em-ployees are in turn agents of top management Thus senior managers, including the chief financial of-
ficer, are simultaneously agents vis-à-vis shareholders and principals vis-à-vis the rest of the firm The
problem is to get everyone working together to maximize value
This chapter summarizes how corporations grapple with that problem as they identify and commit
to capital investment projects We start with basic facts and tradeoffs and end with difficult problems
in performance measurement The main topics are as follows:
• Process: How companies develop plans and budgets for capital investments, how they thorize specific projects, and how they check whether projects perform as promised
au-• Information: Getting accurate information and good forecasts to decision makers
• Incentives: Making sure managers and employees are rewarded appropriately when they addvalue to the firm
• Performance Measurement: You can’t reward value added unless you can measure it Sinceyou get what you reward, and reward what you measure, you get what you measure Make sureyou are measuring the right thing
In each case we will summarize standard practice and warn against common mistakes The section
on incentives probes more deeply into principal–agent relationships The last two sections of thechapter describe performance measures, including residual income and economic value added Wealso uncover the biases lurking in accounting rates of return The pitfalls in measuring profitability areserious but are not as widely recognized as they should be
311
For most large firms, the investment process starts with preparation of an annual
capital budget,which is a list of investment projects planned for the coming year.Since the capital budget does not give the final go-ahead to spend money, the de-scription of each project is not as detailed at this stage as it is later
Most firms let project proposals bubble up from plants, product lines, or gional operations for review by divisional management and then from divisionsfor review by senior management and their planning staff Of course middle man-agers cannot identify all worthwhile projects For example, the managers of plants
re-A and B cannot be expected to see the potential economies of closing their plantsand consolidating production at a new plant C Divisional managers would pro-pose plant C Similarly, divisions 1 and 2 may not be eager to give up their owncomputers to a corporationwide information system That proposal would comefrom senior management
12.1 THE CAPITAL INVESTMENT PROCESS
Trang 3Preparation of the capital budget is not a rigid, bureaucratic exercise There isplenty of give-and-take and back-and-forth Divisional managers negotiate withplant managers and fine-tune the division’s list of projects There may be specialanalyses of major outlays or ventures into new areas
The final capital budget must also reflect the corporation’s strategic planning.Strategic planning takes a top-down view of the company It attempts to identifybusinesses in which the company has a competitive advantage It also attempts toidentify businesses to sell or liquidate and declining businesses that should be al-lowed to run down
In other words, a firm’s capital investment choices should reflect both tom-up and top-down processes—capital budgeting and strategic planning, re-spectively The two processes should complement each other Plant and divisionmanagers, who do most of the work in bottom-up capital budgeting, may notsee the forest for the trees Strategic planners may have a mistaken view of theforest because they do not look at the trees one by one
bot-Project Authorizations
Once the capital budget has been approved by top management and the board ofdirectors, it is the official plan for the ensuing year However, it is not the final sign-
off for specific projects Most companies require appropriation requests for each
proposal These requests include detailed forecasts, discounted-cash-flow ses, and backup information
analy-Because investment decisions are so important to the value of the firm, final proval of appropriation requests tends to be reserved for top management Compa-nies set ceilings on the size of projects that divisional managers can authorize Oftenthese ceilings are surprisingly low For example, a large company, investing $400 mil-lion per year, might require top management approval of all projects over $500,000
ap-Some Investments May Not Show Up in the Capital Budget
The boundaries of capital expenditure are often imprecise Consider the ments in information technology, or IT (computers, software and systems, train-ing, and telecommunications), made by large banks and securities firms These
invest-investments soak up hundreds of millions of dollars annually, and some multiyear
IT projects have costs well over $1 billion Yet much of this expenditure goes to tangibles such as system design, testing, or training Such outlays often bypasscapital expenditure controls, particularly if the outlays are made piecemeal ratherthan as large, discrete commitments
in-Investments in IT may not appear in the capital budget, but for financial tutions they are much more important than outlays for plant and equipment Anefficient information system is a valuable asset for any company, especially if it al-lows the company to offer a special product or service to its customers Thereforeoutlays for IT deserve careful financial analysis
insti-Here are some further examples of important investments that rarely appear onthe capital budget
Research and Development For many companies, the most important asset istechnology The technology is embodied in patents, licenses, unique products orservices, or special production methods The technology is generated by invest-ment in research and development (R&D)
Trang 4R&D budgets for major pharmaceutical companies routinely exceed $1 billion.
Glaxo Smith Kline, one of the largest pharmaceutical companies, spent nearly $4
billion on R&D in 2000 The R&D cost of bringing one new prescription drug to
market has been estimated at over $300 million.1
Marketing In 1998 Gillette launched the Mach3 safety razor It had invested $750
million in new, custom machinery and renovated production facilities It planned
to spend $300 million on the initial marketing program Its goal was to make the
Mach3 a long-lived, brand-name, cash-cow consumer product This marketing
outlay was clearly a capital investment, because it was cash spent to generate
fu-ture cash inflows
Training and Personnel Development By launch of the Mach3, Gillette had hired
160 new workers and paid for 30,000 hours of training
Small Decisions Add Up Operating managers make investment decisions every
day They may carry extra inventories of raw materials or spare parts, just to be
sure they won’t be caught short Managers at the confabulator plant in Quayle City,
Arkansas, may decide they need one more forklift or a cappuccino machine for the
cafeteria They may hold on to an idle machine tool or an empty warehouse that
could have been sold These are not big investments ($5,000 here, $40,000 there) but
they add up
How can the financial manager assure that small investments are made for the
right reasons? Financial staff can’t second-guess every operating decision They
can’t demand a discounted-cash-flow analysis of a cappuccino machine Instead
they have to make operating managers conscious of the cost of investment and
alert for investments that add value We return to this problem later in the chapter
Our general point is this: The financial manager has to consider all investments,
regardless of whether they appear in the formal capital budget The financial
man-ager has to decide which investments are most important to the success of the
com-pany and where financial analysis is most likely to pay off The financial manager
in a pharmaceutical company should be deeply involved in decisions about R&D
In a consumer goods company, the financial manager should play a key role in
marketing decisions to develop and launch new products
Postaudits
Most firms keep a check on the progress of large projects by conducting postaudits
shortly after the projects have begun to operate Postaudits identify problems that
need fixing, check the accuracy of forecasts, and suggest questions that should
have been asked before the project was undertaken Postaudits pay off mainly by
helping managers to do a better job when it comes to the next round of
invest-ments After a postaudit the controller may say, “We should have anticipated the
extra working capital needed to support the project.” When the next proposal
ar-rives, working capital will get the attention it deserves
Postaudits may not be able to measure all cash flows generated by a project It
may be impossible to split the project away from the rest of the business Suppose
1 This figure is for drugs developed in the late 1980s and early 1990s It is after-tax, stated in 1994
dol-lars The comparable pretax figure is over $400 million See S C Myers and C D Howe, A Life-Cycle
Model of Pharmaceutical R&D, MIT Program on the Pharmaceutical Industry, 1997.
Trang 5that you have just taken over a trucking firm that operates a merchandise deliveryservice for local stores You decide to revitalize the business by cutting costs andimproving service This requires three investments:
1 Buying five new diesel trucks
2 Constructing a dispatching center
3 Buying a computer and special software to keep track of packages andschedule trucks
A year later you try a postaudit of the computer You verify that it is workingproperly and check actual costs of purchase, installation, and training against pro-jections But how do you identify the incremental cash inflows generated by the
computer? No one has kept records of the extra diesel fuel that would have been used
or the extra shipments that would have been lost had the computer not been
in-stalled You may be able to verify that service is better, but how much of the provement comes from the new trucks, how much comes from the dispatchingcenter, and how much comes from the new computer? It is impossible to say Theonly meaningful way to judge the success or failure of your revitalization program
im-is to examine the delivery business as a whole.2
2 Even here you don’t know the incremental cash flows unless you can establish what the business would have earned if you had not made the changes.
12.2 DECISION MAKERS NEED GOOD INFORMATION
Good investment decisions require good information Decision makers get such formation only if other managers are encouraged to supply it Here are four infor-mation problems that financial managers need to think about
in-Establishing Consistent Forecasts
Inconsistent assumptions often creep into investment proposals Suppose themanager of your furniture division is bullish on housing starts but the manager ofyour appliance division is bearish This inconsistency makes the furniture divi-sion’s projects look better than the appliance division’s Senior management ought
to negotiate a consensus estimate and make sure that all NPVs are recomputed ing that joint estimate Then projects can be evaluated consistently
us-This is why many firms begin the capital budgeting process by establishing casts of economic indicators, such as inflation and growth in gross national prod-uct, as well as forecasts of particular items that are important to the firm’s business,such as housing starts or the price of raw materials These forecasts can then beused as the basis for all project analyses
fore-Reducing Forecast Bias
Anyone who is keen to get a project accepted is likely to look on the bright sidewhen forecasting the project’s cash flows Such overoptimism seems to be a com-mon feature in financial forecasts Overoptimism afflicts governments too, prob-ably more than private businesses How often have you heard of a new dam,
highway, or military aircraft that actually cost less than was originally forecasted?
Trang 6You will probably never be able to eliminate bias completely, but if you are
aware of why bias occurs, you are at least part of the way there Project sponsors
are likely to overstate their case deliberately only if you, the manager, encourage
them to do so For example, if they believe that success depends on having the
largest division rather than the most profitable one, they will propose large
ex-pansion projects that they do not truly believe have positive NPVs Or if they
be-lieve that you won’t listen to them unless they paint a rosy picture, you will be
presented with rosy pictures Or if you invite each division to compete for limited
resources, you will find that each attempts to outbid the other for those resources
The fault in such cases is your own—if you hold up the hoop, others will try to
jump through it
Getting Senior Management the Information That It Needs
Valuing capital investment opportunities is hard enough when you can do the
en-tire job yourself In real life it is a cooperative effort Although cooperation brings
more knowledge to bear, it has its own problems Some are unavoidable, just
an-other cost of doing business Others can be alleviated by adding checks and
bal-ances to the investment process
Many of the problems stem from sponsors’ eagerness to obtain approval for
their favorite projects As a proposal travels up the organization, alliances are
formed Preparation of the request inevitably involves compromises But, once a
division has agreed on its plants’ proposals, the plants unite in competing against
outsiders
The competition among divisions can be put to good use if it forces division
managers to develop a well-thought-out case for what they want to do But the
competition has its costs as well Several thousand appropriation requests may
reach the senior management level each year, all essentially sales documents
pre-sented by united fronts and designed to persuade Alternative schemes have been
filtered out at an earlier stage The danger is that senior management cannot
ob-tain (let alone absorb) the information to evaluate each project rationally
The dangers are illustrated by the following practical question: Should we
an-nounce a definite opportunity cost of capital for computing the NPV of projects in our
furniture division? The answer in theory is a clear yes, providing that the projects of
the division are all in the same risk class Remember that most project analysis is done
at the plant or divisional level Only a small proportion of project ideas analyzed
sur-vive for submission to top management Plant and division managers cannot judge
projects correctly unless they know the true opportunity cost of capital
Suppose that senior management settles on 12 percent That helps plant
man-agers make rational decisions But it also tells them exactly how optimistic they
have to be to get their pet project accepted Brealey and Myers’s Second Law states:
The proportion of proposed projects having a positive NPV at the official corporate hurdle
This is not a facetious conjecture The law was tested in a large oil company, whose
capital budgeting staff kept careful statistics on forecasted profitability of proposed
projects One year top management announced a big push to conserve cash It
im-posed discipline on capital expenditures by increasing the corporate hurdle rate by
several percentage points But staff statistics showed that the fraction of proposals
3There is no First Law; we thought that “Second Law” sounded better There is a Third Law, but that is
for another chapter.
Trang 7with positive NPVs stayed rock-steady at about 85 percent of all proposals Top agement’s tighter discipline was repaid with expanded optimism
man-A firm that accepts poor information at the top faces two consequences First,senior management cannot evaluate individual projects In a study by Bower of alarge multidivisional company, projects that had the approval of a division generalmanager were seldom turned down by his or her group of divisions, and thosereaching top management were almost never rejected.4Second, since managershave limited control over project-by-project decisions, capital investment decisionsare effectively decentralized regardless of what formal procedures specify Some senior managers try to impose discipline and offset optimism by settingrigid capital expenditure limits This artificial capital rationing forces plant or di-vision managers to set priorities The firm ends up using capital rationing not be-cause capital is truly unobtainable but as a way of decentralizing decisions
Eliminating Conflicts of Interest
Plant and divisional managers are concerned about their own futures Sometimestheir interests conflict with stockholders’ and that may lead to investment deci-sions that do not maximize shareholder wealth For example, new plant managersnaturally want to demonstrate good performance right away, in order to move upthe corporate ladder, so they are tempted to propose quick-payback projects even
if NPV is sacrificed And if their performance is judged on book earnings, they willalso be attracted by projects whose accounting results look good That leads us tothe next topic: how to motivate managers
4
J L Bower, Managing the Resource Allocation Process: A Study of Corporate Planning and Investment,
Divi-sion of Research, Graduate School of Business Administration, Harvard University, Boston, 1970.
12.3 INCENTIVES
Managers will act in shareholders’ interests only if they have the right incentives.Good capital investment decisions therefore depend on how managers’ perfor-mance is measured and rewarded
We start this section with an overview of agency problems encountered in ital investment, and then we look at how top management is actually compen-sated Finally we consider how top management can set incentives for the middlemanagers and other employees who actually operate the business
cap-Overview: Agency Problems in Capital Budgeting
As you have surely guessed, there is no perfect system of incentives But it’s easy
to see what won’t work Suppose shareholders decide to pay the financial managers
a fixed salary—no bonuses, no stock options, just $X per month The manager, asthe stockholders’ agent, is instructed to find and invest in all positive-NPV projectsopen to the firm The manager may sincerely try to do so, but will face varioustempting alternatives:
Reduced effort.Finding and implementing investment in truly valuableprojects is a high-effort, high-pressure activity The financial manager will betempted to slack off
Trang 8Perks.Our hypothetical financial manager gets no bonuses Only $X per
month But he or she may take a bonus anyway, not in cash, but in tickets
to sporting events, lavish office accommodations, planning meetings
scheduled at luxury resorts, and so on Economists refer to these
nonpecuniary rewards as private benefits Ordinary people call them
perks (short for perquisites.)
Empire building.Other things equal, managers prefer to run large businesses
rather than small ones Getting from small to large may not be a positive-NPV
undertaking
Entrenching investment.Suppose manager Q considers two expansion plans
One plan will require a manager with special skills that manager Q just
happens to have The other plan requires only a general-purpose manager
Guess which plan Q will favor Projects designed to require or reward the
skills of existing managers are called entrenching investments.5
Entrenching investments and empire building are typical symptoms of
overinvestment, that is, investing beyond the point where NPV falls to zero
The temptation to overinvest is highest when the firm has plenty of cash but
limited investment opportunities Michael Jensen calls this a free-cash-flow
problem: “The problem is how to motivate managers to disgorge the cash
rather than investing it below the cost of capital or wasting it in organizational
inefficiencies.”6
Avoiding risk.If a financial manager receives only a fixed salary, and cannot
share in the upside of risky projects, then safe projects are, from the
manager’s viewpoint, better than risky ones But risky projects can have
large, positive NPVs
A manager on a fixed salary could hardly avoid all these temptations all of the
time The resulting loss in value is an agency cost
Monitoring
Agency costs can be reduced in two ways: by monitoring the managers’ effort and
actions and by giving them the right incentives to maximize value
Monitoring can prevent the more obvious agency costs, such as blatant perks or
empire building It can confirm that the manager is putting sufficient time on the
job But monitoring costs time, effort, and money Some monitoring is almost
al-ways worthwhile, but a limit is soon reached at which an extra dollar spent on
monitoring would not return an extra dollar of value from reduced agency costs
Like all investments, monitoring encounters diminishing returns
Some agency costs can’t be prevented even with spendthrift monitoring
Sup-pose a shareholder undertakes to monitor capital investment decisions How could
he or she ever know for sure whether a capital budget approved by top
manage-ment includes (1) all the positive-NPV opportunities open to the firm and (2) no
projects with negative NPVs due to empire-building or entrenching investments?
The managers obviously know more about the firm’s prospects than outsiders ever
can If the shareholder could list all projects and their NPVs, then the managers
would hardly be needed!
5 A Shleifer and R W Vishny, “Management Entrenchment: The Case of Manager-Specific
Invest-ments,” Journal of Financial Economics 25 (November 1989), pp 123–140.
6M C Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic
Review 76 (May 1986), p 323.
Trang 9Who actually does the monitoring? Ultimately it is the shareholders’
responsi-bility, but in large, public companies, monitoring is delegated to the board of
direc-tors, who are elected by shareholders and are supposed to represent their interests.The board meets regularly, both formally and informally, with top management.Attentive directors come to know a great deal about the firm’s prospects and per-formance and the strengths and weaknesses of its top management
The board also hires independent accountants to audit the firm’s financialstatements If the audit uncovers no problems, the auditors issue an opinion thatthe financial statements fairly represent the company’s financial condition and areconsistent with generally accepted accounting principles (GAAP, for short)
If problems are found, the auditors will negotiate changes in assumptions or cedures Managers almost always agree, because if acceptable changes are not made,
pro-the auditors will issue a qualified opinion, which is bad news for pro-the company and its
shareholders A qualified opinion suggests that managers are covering something upand undermines investors’ confidence that they can monitor effectively
A qualified opinion may be bad news, but when investors learn of accountingproblems that have escaped detection by auditors, there’s hell to pay On April 15,
1998, Cendant Corporation announced discovery of serious accounting ties The next day Cendant shares fell by about 46 percent, wiping $14 billion offthe market value of the company.7
irregulari-Lenders also monitor If a company takes out a large bank loan, the bank willtrack the company’s assets, earnings, and cash flow By monitoring to protect itsloan, the bank protects shareholders’ interests also.8
Delegated monitoring is especially important when ownership is widely persed If there is a dominant shareholder, he or she will generally keep a close eye
dis-on top management But when the number of stockholders is large, and each holding is small, individual investors cannot justify much time and expense formonitoring Each is tempted to leave the task to others, taking a free ride on oth-ers’ efforts But if everybody prefers to let somebody else do it, then it won’t getdone; that is, monitoring by shareholders will not be strong or effective Econo-
stock-mists call this the free-rider problem.9
in the company Investigations were continuing See E Nelson and J S Lubin “Buy the Numbers? How
Whistle-Blowers Set Off a Fraud Probe That Crushed Cendant,” The Wall Street Journal (August 13,
1998), pp A1, A8
8
Lenders’ and shareholders’ interests are not always aligned—see Chapter 18 But a company’s ability
to satisfy lenders is normally good news for stockholders, particularly when lenders are well placed to
monitor See C James “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial
Econom-ics 19 (December 1987), pp 217–235
9
The free-rider problem might seem to drive out all monitoring by dispersed shareholders But vestors have another reason to investigate: They want to make money on their common stock portfo- lios by buying undervalued companies and selling overvalued ones To do this they must investigate companies’ performance.
Trang 10in-Compensation can be based on input (for example, the manager’s effort or
demonstrated willingness to bear risk) or on output (actual return or value added
as a result of the manager’s decisions) But input is so difficult to measure; for
ex-ample, how does an outside investor observe effort? Therefore incentives are
al-most always based on output The trouble is that output depends not just on the
manager’s decisions but also on many other events outside his or her control
The fortunes of a business never depend only on the efforts of a few key
indi-viduals The state of the economy or the industry is usually at least as important
for the firm’s success Unless you can separate out these influences, you face a
dilemma You want to provide managers with a high-powered incentive, so that
they capture all the benefits of their contributions to the firm, but such an
arrangement would load onto the managers all the risk of fluctuations in the
firm’s value Think of what this would mean in the case of GE, where in a
reces-sion income can fall by more than $1 billion No group of managers would have
the wealth to stump up a significant fraction of $1 billion, and they would
cer-tainly be reluctant to take on the risk of huge personal losses in a recession A
re-cession is not their fault
The result is a compromise Firms do link managers’ pay to performance, but
fluctuations in firm value are shared by managers and shareholders Managers
bear some of the risks that are outside their control and shareholders bear some of
the agency costs if managers shirk, empire build, or otherwise fail to maximize
value Thus, some agency costs are inevitable For example, since managers split
the gains from hard work with the stockholders but reap all the personal benefits
of an idle or indulgent life, they will be tempted to put in less effort than if
share-holders could reward their effort perfectly
If the firm’s fortunes are largely outside managers’ control, it makes sense to
of-fer the managers low-powered incentives In such cases the managers’
compensa-tion should be largely in the form of a fixed salary If success depends almost
ex-clusively on individual skill and effort, then managers are given high-powered
incentives and end up bearing substantial risks For example, a large part of the
compensation of traders and salespeople in securities firms is in the form of
bonuses or stock options
How do managers of large corporations share in the fortunes of their firms?
Michael Jensen and Kevin Murphy found that the median holding of chief
ex-ecutive officers (CEOs) in their firms was only 14 percent of the outstanding
shares On average, for every $1,000 addition to shareholder wealth, the CEO
re-ceived $3.25 in extra compensation Jensen and Murphy conclude that
“corpo-rate America pays its most important leaders like bureaucrats,” and ask “Is it
any wonder then that so many CEOs act like bureaucrats rather than the
value-maximizing entrepreneurs companies need to enhance their standing in world
markets?”10
Jensen and Murphy may overstate their case It is true that managers bear only
a small portion of the gains and losses in firm value However, the payoff to the
manager of a large, successful firm can still be very large For example, when
10
M C Jensen and K Murphy, “CEO Incentives—It’s Not How Much You Pay, But How,” Harvard
Busi-ness Review 68 (May–June 1990), p 138 The data for Jensen and Murphy’s study ended in 1983 Hall
and Liebman have updated the study and argue that the sensitivity of compensation to changes in firm
value has increased significantly See B J Hall and J B Liebman, “Are CEOs Really Paid Like
Bureau-crats?” Harvard University working paper, August 1997.
Trang 11Michael Eisner was hired as CEO by the Walt Disney Company, his compensationpackage had three main components: a base annual salary of $750,000; an annualbonus of 2 percent of Disney’s net income above a threshold of normal profitabil-ity; and a 10-year option that allowed him to purchase 2 million shares of stock for
$14 a share, which was about the price of Disney stock at the time As it turned out,
by the end of Eisner’s six-year contract the value of Disney shares had increased
by $12 billion, more than sixfold While Eisner received only 1.6 percent of that gain
in value as compensation, this still amounted to $190 million.11Because most CEOs own stock and stock options in their firms, managers ofpoorly performing firms often actually lose money; they also often lose their jobs.For example, a study of the remuneration of the chief executives of large U.S firmsfound that the heads of firms that were in the top 10 percent in terms of stock mar-ket performance received over $9 million more in compensation than theirbrethren at the bottom 10 percent of the spectrum.12
Chief executives in the United States are generally paid more than those in othercountries and their pay is more closely tied to stock returns For example, Kaplanfound that top managers in the United States earn salary plus bonus five times that
of their Japanese counterparts, although Japanese managers receive more noncashcompensation The United States managers’ stakes in their companies averagedmore than double the Japanese managers’ stakes.13
In the ideal incentive scheme, management should bear all the consequences oftheir own actions, but should not be exposed to the fluctuations in firm value overwhich they have no control That raises a question: Managers are not responsiblefor fluctuations in the general level of the stock market So why don’t companiestie top management’s compensation to stock returns relative to the market or to thefirm’s close competitors? This would tie managers’ compensation somewhat moreclosely to their own contributions
Tying top management compensation to stock prices raises another difficult sue The market value of a company’s shares reflects investors’ expectations Thestockholders’ return depends on how well the company performs relative to ex-pectations For example, suppose a company announces the appointment of anoutstanding new manager The stock price leaps up in anticipation of improvedperformance Thenceforth, if the new manager delivers exactly the good perfor-mance that investors expected, the stock will earn only a normal, average rate ofreturn In this case a compensation scheme linked to the stock return would fail torecognize the manager’s special contribution
is-11
We don’t know whether Michael Eisner’s contribution to the firm over the six-year period was more
or less than $190 million However, one of the benefits of paying such a large sum to the CEO is that it provides a wonderful incentive for junior managers to compete for the prize In effect the firm runs a
tournament, in which there is a large prize for the winner and considerably smaller prizes for
runners-up The incentive effects of tournaments show up dramatically in PGA golf tournaments Players who enter the final round within striking distance of big prize money perform much better than their past records would predict Those who receive only a small increase in prize money by moving up the rank- ing are more inclined to relax and deliver only average performance See R G Ehrenberg and M L Bog-
nanno, “Do Tournaments Have Incentive Effects?” Journal of Political Economy 6 (December 1990),
pp 1307–1324
12
See B J Hall and J B Liebman, op cit.
13
S Kaplan, “Top Executive Rewards and Firm Performance: A Comparison of Japan and the USA,”
Journal of Political Economy 102 (June 1994), pp 510–546.
Trang 12Almost all top executives of firms with publicly traded shares have compensation
packages that depend in part on their firms’ stock price performance But their
compensation also depends on increases in earnings or on other accounting
mea-sures of performance For lower-level managers, compensation packages usually
depend more on accounting measures and less on stock returns
Accounting measures of performance have two advantages:
• They are based on absolute performance, rather than on performance relative
to investors’ expectations
• They make it possible to measure the performance of junior managers whose
responsibility extends to only a single division or plant
Tying compensation to accounting profits also creates some obvious problems
First, accounting profits are partly within the control of management For example,
managers whose pay depends on near-term earnings may cut maintenance or staff
training This is not a recipe for adding value, but an ambitious manager hoping
for a quick promotion will be tempted to pump up short-term profits, leaving
longer-run problems to his or her successors
Second, accounting earnings and rates of return can be severely biased
mea-sures of true profitability We ignore this problem for now, but return to it in the
next section
Third, growth in earnings does not necessarily mean that shareholders are
better off Any investment with a positive rate of return (1 or 2 percent will do)
will eventually increase earnings Therefore, if managers are told to maximize
growth in earnings, they will dutifully invest in projects offering 1 or 2 percent
rates of return—projects that destroy value But shareholders don’t want growth
in earnings for its own sake, and they are not content with 1 or 2 percent returns
They want positive-NPV investments, and only positive-NPV investments They
want the company to invest only if the expected rate of return exceeds the cost
of capital
In short, managers ought not to forget the cost of capital In judging their
per-formance, the focus should be on value added, that is, on returns over and above
the cost of capital
Look at Table 12.1, which contains a simplified income statement and balance
sheet for your company’s Quayle City confabulator plant There are two methods
for judging whether the plant has increased shareholder value
Net Return on Investment Does the return on investment exceed the cost of
capital? The net return to investment method calculates the difference
be-tween them
As you can see from Table 12.1, your corporation has invested $1,000 million
($1 billion) in the Quayle City plant.14The plant’s net earnings are $130 million
Therefore the firm is earning a return on investment (ROI) of 130/1,000 ⫽ 13 or
12.4 MEASURING AND REWARDING PERFORMANCE:
RESIDUAL INCOME AND EVA
14
In practice, investment would be measured as the average of beginning- and end-of-year assets See
Chapter 29.
Trang 1313 percent.15If the cost of capital is (say) 10 percent, then the firm’s activities are
adding to shareholder value The net return is 13 ⫺ 10 ⫽ 3 percent If the cost ofcapital is (say) 20 percent, then shareholders would have been better off invest-ing $1 billion somewhere else In this case the net return is negative, at 13 ⫺ 20 ⫽
⫺7 percent
Residual Income or Economic Value Added (EVA ©) 16 The second method lates a net dollar return to shareholders It asks, What are earnings after deducting
calcu-a chcalcu-arge for the cost of ccalcu-apitcalcu-al?
When firms calculate income, they start with revenues and then deduct costs, such
as wages, raw material costs, overhead, and taxes But there is one cost that they donot commonly deduct: the cost of capital True, they allow for depreciation of the as-sets financed by investors’ capital, but investors also expect a positive return on theirinvestment As we pointed out in Chapter 10, a business that breaks even in terms ofaccounting profits is really making a loss; it is failing to cover the cost of capital
To judge the net contribution to value, we need to deduct the cost of capital tributed to the plant by the parent company and its stockholders For example,suppose that the cost of capital is 12 percent Then the dollar cost of capital for theQuayle City plant is 12 ⫻ $1,000 ⫽ $120 million The net gain is therefore 130 ⫺
con-120 ⫽ $10 million This is the addition to shareholder wealth due to management’shard work (or good luck)
Net income after deducting the dollar return required by investors is called
residual income, economic value added, or EVA The formula is
For our example, the calculation is
EVA⫽ residual income ⫽ 130 ⫺ 1.12 ⫻ 1,0002 ⫽ ⫹$10 million
⫽ income earned ⫺ cost of capital ⫻ investment EVA⫽ residual income ⫽ income earned ⫺ income required
Sales $550 Net working capital† $80 Cost of goods sold* 275 Property, plant, and
equipment investment 1,170 Selling, general, and Less cumulative
administrative expenses 75 depreciation 360
200 Net investment 810 Taxes at 35% 70 Other assets 110 Net income $130 Total assets $1,000
T A B L E 1 2 1
Simplified statements of
income and assets for
the Quayle City
16 EVA is the term used by the consulting firm Stern–Stewart, which has done much to popularize and implement this measure of residual income With Stern–Stewart’s permission, we omit the copyright symbol in what follows.
Trang 14But if the cost of capital were 20 percent, EVA would be negative by $70 million
Net return on investment and EVA are focusing on the same question When
return on investment equals the cost of capital, net return and EVA are both zero
But the net return is a percentage and ignores the scale of the company EVA
rec-ognizes the amount of capital employed and the number of dollars of additional
wealth created
A growing number of firms now calculate EVA and tie management
compensa-tion to it.17They believe that a focus on EVA can help managers concentrate on
in-creasing shareholder wealth One example is Quaker Oats:
Until Quaker adopted [EVA] in 1991, its businesses had one overriding
goal—in-creasing quarterly earnings To do it, they guzzled capital They offered sharp
price discounts at the end of each quarter, so plants ran overtime turning out huge
shipments of Gatorade, Rice-A-Roni, 100% Natural Cereal, and other products.
Managers led the late rush, since their bonuses depended on raising profits each
quarter
This is the pernicious practice known as trade loading (because it loads up the
trade, or retailers, with product) and many consumer product companies are finally
admitting it damages long-run returns An important reason is that it demands so
much capital Pumping up sales requires many warehouses (capital) to hold vast
temporary inventories (more capital) But who cared? Quaker’s operating
busi-nesses paid no charge for capital in internal accounting, so they barely noticed It
took EVA to spot the problem 18
When Quaker Oats implemented EVA, most of the capital-guzzling stopped
The term EVA has been popularized by the consulting firm Stern–Stewart But
the concept of residual income has been around for some time,19and many
com-panies that are not Stern–Stewart clients use this concept to measure and reward
managers’ performance
Other consulting firms have their own versions of residual income McKinsey &
Company uses economic profit (EP), defined as capital invested multiplied by the
spread between return on investment and the cost of capital This is another
ex-pression of the concept of residual income For the Quayle City plant, with a 12
percent cost of capital, economic profit is the same as EVA:
Pros and Cons of EVA
Let’s start with the pros EVA, economic profit, and other residual income
mea-sures are clearly better than earnings or earnings growth for measuring
perfor-mance A plant or division that’s generating lots of EVA should generate accolades
⫽ 1.13 ⫺ 122 ⫻ 1,000 ⫽ $10 million Economic profit⫽ EP ⫽ 1ROI ⫺ r2 ⫻ capital invested
17 It can be shown that compensation plans that are linked to economic value added can induce a
man-ager to choose the efficient investment level See W P Rogerson, “International Cost Allocation and
Managerial Incentives: A Theory Explaining the Use of Economic Value Added as a Performance
Mea-sure,” Journal of Political Economy 4 (August 1977), pp 770–795
18Shawn Tully, “The Real Key to Creating Shareholder Wealth,” Fortune (September 20, 1993), p 48
19 EVA is conceptually the same as the residual income measure long advocated by some accounting
scholars See, for example, R Anthony, “Accounting for the Cost of Equity,” Harvard Business Review 51
(1973), pp 88–102 and “Equity Interest—Its Time Has Come,” Journal of Accountancy 154 (1982),
pp 76–93.
Trang 15for its managers as well as value for shareholders EVA may also highlight parts ofthe business that are not performing up to scratch If a division is failing to earn apositive EVA, its management is likely to face some pointed questions aboutwhether the division’s assets could be better employed elsewhere
EVA sends a message to managers: Invest if and only if the increase in ings is enough to cover the cost of capital For managers who are used to track-ing earnings or growth in earnings, this is a relatively easy message to grasp.Therefore EVA can be used down deep in the organization as an incentive com-pensation system It is a substitute for explicit monitoring by top management
earn-Instead of telling plant and divisional managers not to waste capital and then
trying to figure out whether they are complying, EVA rewards them for carefuland thoughtful investment decisions Of course, if you tie junior managers’compensation to their economic value added, you must also give them powerover those decisions that affect EVA Thus the use of EVA implies delegated decision-making
EVA makes the cost of capital visible to operating managers A plant manager can improve EVA by (a) increasing earnings or (b) reducing capital employed.
Therefore underutilized assets tend to be flushed out and disposed of Workingcapital may be reduced, or at least not added to casually, as Quaker Oats did bytrade loading in its pre-EVA era The plant managers in Quayle City may decide to
do without that cappuccino machine or extra forklift
Introduction of residual income measures often leads to surprising reductions
in assets employed—not from one or two big capital disinvestment decisions, butfrom many small ones Ehrbar quotes a sewing machine operator at Herman MillerCorporation:
[EVA] lets you realize that even assets have a cost we used to have these stacks
of fabric sitting here on the tables until we needed them We were going to use the fabric anyway, so who cares that we’re buying it and stacking it up there? Now
no one has excess fabric They only have the stuff we’re working on today And it’s changed the way we connect with suppliers, and we’re having [them] deliver fab- ric more often.20
Now we come to the first limitation to EVA It does not involve forecasts of ture cash flows and does not measure present value Instead, EVA depends on the
fu-current level of earnings It may, therefore, reward managers who take on projects
with quick paybacks and penalize those who invest in projects with long gestationperiods Think of the difficulties in applying EVA to a pharmaceutical research pro-gram, where it typically takes 10 to 12 years to bring a new drug from discovery tofinal regulatory approval and the drug’s first revenues That means 10 to 12 years
of guaranteed losses, even if the managers in charge do everything right Similarproblems occur in startup ventures, where there may be heavy capital outlays butlow or negative earnings in the first years of operation This does not imply nega-tive NPV, so long as operating earnings and cash flows are sufficiently high later
on But EVA would be negative in the startup years, even if the project were ontrack to a strong positive NPV
The problem in these cases lies not so much in EVA as in the measurement of come The pharmaceutical R&D program may be showing accounting losses, be-
in-20A Ehrbar, EVA: The Real Key to Creating Wealth, John Wiley & Sons, Inc., New York, 1998, pp 130–131.
Trang 16cause generally accepted accounting principles require that outlays for R&D be
written off as a current expense But from an economic point of view, the outlays
are an investment, not an expense If a proposal for a new business forecasts
ac-counting losses during a startup period, but the proposal nevertheless shows
pos-itive NPV, then the startup losses are really an investment—cash outlays made to
generate larger cash inflows when the new business hits its stride
In short, EVA and other measures of residual income depend on accurate
mea-sures of economic income and investment Applying EVA effectively requires
ma-jor changes in income statements and balance sheets.21We will pick up this point
in the next section
Applying EVA to Companies
EVA’s most important use is in measuring and rewarding performance inside the
firm But it can also be applied to firms as a whole Business periodicals regularly
report EVAs for companies and industries Table 12.2 shows the economic value
added in 2000 for a sample of U.S companies.22 Notice that the firms with the
highest return on capital did not necessarily add the most economic value For
ex-ample, Philip Morris was top of the class in terms of economic value added, but its
return on capital was less than half that of Microsoft This is partly because Philip
Morris has more capital invested and partly because it is less risky than Microsoft
and its cost of capital is correspondingly lower
21 For example, R&D should not be treated as an immediate expense but as an investment to be added
to the balance sheet and written off over a reasonable period Eli Lilly, a large pharmaceutical company,
did this so that it could use EVA As a result, the net value of its assets at the end of 1996 increased from
$6 to $13 billion.
22 Stern–Stewart makes some adjustments to income and assets before calculating these EVAs, but it is
almost impossible to include the value of all assets For example, did Microsoft really earn a 39 percent
true, economic rate of return? We suspect that the value of its assets is understated The value of its
in-tellectual property—the fruits of its investment over the years in software and operating systems—is
not shown on the balance sheet If the denominator in a return on capital calculation is too low, the
re-sulting profitability measure is too high.
Economic Value Added Capital Return on Cost of (EVA) Invested Capital Capital Philip Morris $6,081 $57,220 17.4% 6.7%
Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Coca- Cola EVA ⫽ (.157 ⫺ 092) ⫻ 19,523 ⫽ $1,266 Source: Data provided
by Stern–Stewart.