Management Compensation

1
Management Compensation

• 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

2
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.

3
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
  post-horizon flows. Estimating the terminal value
  requires careful attention, because it often
  accounts for the majority of the value of the
  company.

4
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.

5
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 firms debt
• Preferred stock often has a preset dividend rate

6
WACC Debt Ratios

• Example continued Sangria and the Perpetual
  Crusher project at 20 D/V
• Step 1 r at current debt of 40
• Step 2 D/V changes to 20
• Note the debt-equity ratio is .2/.8 .25
• Step 3 New WACC

7
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

8
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.

9
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
• Dont do the project

10
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.

11
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

12
Adjusted Present Value
Example Rio Corporation APV
13
Adjusted Present Value
Example Rio Corporation APV - continued
14

• 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

15
Capital Investment Process

• Capital budgeting
• Bottom-up
• Strategic planning
• Top-down
• Project authorizations
• Investments missing from capital budget
• Information technology (IT)
• Research and development
• Marketing
• Training
• Post audits
• What can be learned for next time

16
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

17
Incentives

• Agency problems in capital budgeting
• Reduced effort
• Perks
• Empire building
• Entrenching investment
• Avoiding risk
• Ways to reduce agency costs
• Monitoring
• Incentives

18
Monitoring Management of a Public Corporation

• Stockholders
• Small stockholders
• Large investors
• Individuals
• Pension fund
• Mutual fund
• Board of directors
• Auditors
• Lenders
• Rating agencies

19
Incentives

• Management compensation
• Basic
• Bonus
• Benefits
• Perks
• Options
• CEO compensation relative to other employees
• US
• Internationally

20
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

21
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

22
Black-Scholes Option Pricing Model

• C Price of a call option
• S Current price of the asset
• X Exercise price
• r Risk free interest rate
• t Time to expiration of the option
• s Volatility of the stock price
• N Normal distribution function

23
Black-Scholes Option Pricing Model

• Values European options on stock
• Assumptions
• 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

24
Using the Black-Scholes Model

• Only variables needed
• Underlying stock price
• Exercise price
• Time to expiration
• Volatility of stock price
• Risk-free interest rate

25
Example

• What is the value of call options on 100,000
  shares of stock under the following
• Current stock price 20
• Exercise price 20
• Time to expiration 5 years
• Standard deviation of stock returns .25
• Risk-free rate 5

26
Value of Each Option
27
Total Value of Option Grant100,000 x 6.50
650,000

• Ways to increase this value even more
• Increase s
• 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

28
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

29
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

30

• 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) 0
• B) 50
• C) 100
• D) 120
• E) None of the above

31
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

32
Next Class

• Thursday, April 17
• Integrating Capital and Risk
• Reading The Insurative Model by Prakash Shimpi,
  Risk Management August 2001 http//www.rmmag.com/M
  agazine/PDF/Insurative_Model.pdf