Ch 12

CHAPTER 12

Agency Problems, Compensation,

and Performance Measurement

Answers to Problem Sets

1. a. True

b. True

c. False

d. True

2. a. Agency costs: value lost when managers do not act to maximize value.

This includes costs of monitoring and control.

b. Private benefits: perks or other advantages enjoyed by managers.

c. Empire building: investing for size, not NPV.

d. Free-rider problem: when one shareholder, or group of shareholders, acts to monitor and control management, all shareholders benefit.

e. Entrenching investment: managers choose or design investment projects that increase the managers’ value to the firm.

f. Delegated monitoring: monitoring on behalf of principals. For example, the board of directors monitors management performance on behalf of stockholders.

3. Monitoring is costly and encounters diminishing returns. Also, completely effective monitoring would require perfect information.

4. a. Dollar amount

b. EVA = Income earned - (cost of capital X investment)

c. They are essentially the same

d. EVA makes the cost of capital visible to managers. Compensation based

on EVA encourages them to dispose of unnecessary assets and to forego investment unless it earns more than the cost of capital

e. Yes.

5. ROI = 1.6/20 = .08 or 8%. Net return = 8 - 11.5 = -3.5%. EVA = 1.6 - (.115 X 20) = -$.7 million. EVA is negative.

6. Cash flow, economic, less, greater.

7. Not usually by creative accounting, but by reducing or delaying discretionary advertising, maintenance, R&D, or other expenses.

8. The typical compensation and incentive plans for top management include salary plus profit sharing and stock options. This is usually done to align as closely as possible the interests of the manager with the interests of the shareholders. These managers are...