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- 2

Topics Covered
 The capital investment process
 Decision Makers and Information
 Incentives
 Residual Income and EVA
 Accounting Performance Measures
 Economic Profit

Irwin/McGraw Hill

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12- 3

The Principal Agent Problem
Shareholders = Owners

Question: Who has
the power?

Answer: Managers
Managers = Employees

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12- 4

Capital Investment Decision
Strategic Planning
“Top Down”

Capital Investments

Project Creation
“Bottom Up”
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12- 5

Off Budget Expenditures
Information Technology
Research and Development
Marketing
Training and Development

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12- 6

Information Problems

The correct
information
is …

Irwin/McGraw Hill

1. Consistent Forecasts
2. Reducing Forecast Bias
3. Getting Senior Management
Needed Information

4. Eliminating Conflicts of
Interest

©The McGraw-Hill Companies, Inc., 200


12- 7

Growth and Returns
Rate of return, %
12
11
Economic rate of return

10
9
8

Book rate of return

7

5

Irwin/McGraw Hill

10

15


20

25

Rate of
growth,
%

©The McGraw-Hill Companies, Inc., 200


12- 8

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.

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©The McGraw-Hill Companies, Inc., 200


12- 9

Incentives
Agency Problems in Capital Budgeting
 Reduced effort

 Perks
 Empire building
 Entrenching investment
 Avoiding risk

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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

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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

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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 × Investment]
© 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

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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 ) × Capital Invested
© 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) × 1,000
= $10million
© 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

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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 .8
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 .0

14.5
11 .8
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

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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

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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
3
4
250
298
901
741

5
298

517

6
298
271

1
100
1000

2
200
1000

1000

901

741

517

271

0

0

-99


-160

-224

-246

-271

100

101

90

74

52

27

10

10

10

10

10


10

0

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

1
100
1000

2
200
833

YEAR
3
4
250
298
667
500

833

667

500

-167
-67
-6.7
167


-167
+33
4.0
167

333

5
298
333

6
298
167

167

0

-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