CHAPTER 12

Making Sure Managers Maximize NPV

 

 

Answers to Practice Questions

 

1.                  Post-audits provide information on problems that may need to be corrected in order for newly completed projects to operate as intended.  Also, the postaudit provides preliminary data on the validity of the forecasts for the project and the corrections that may be needed in this process.

 

The postaudit should be performed by a disinterested party.  It should not be done by someone involved in the operations of the project or someone responsible for its planning.  The postaudit should be performed after resolving any minor “bugs” that occur during the start-up process.  Once this stage has been reached, the postaudit should investigate all phases of the project, both financial and technical.

 

The issue of which projects to audit depends on the cost of performing audits and on the value of the information obtained.  Larger projects usually require audits in order to be certain that everything performs as expected.  If there are unexpected problems, it is generally advisable to find out about them as soon as possible.  Postaudits for smaller projects might make sense when a series of projects of a given type can be investigated.  Standardized postaudit procedures can be developed and statistical analyses performed.

 

 

2.                  Outline of steps in capital budgeting process:

(1)              Plant manager gets idea, does some very rough estimates, and determines whether idea is worth pursuing.

(2)              Staff of plant manager develops detailed proposal, including:

·        Discussion of reason that the company should invest in this machine

·        Economic forecasts

·        Demand forecasts

·        Cash flow forecasts, both revenue and expenses

·        Estimate of cost of capital (unless specified at a higher level)

·        Net present value or internal rate of return calculation

(3)              Proposal is evaluated by division level staff.  If approved, proposal is evaluated at company level.

(4)              Project authorization is requested, which may require a final check/revision of the numbers in the original proposal.

(5)              Purchase and installation proceed.  If there are significant cost overruns, these must be re-approved by the division and company staff.

(6)              When the machine is up and running, say after one year, a postaudit might be conducted to evaluate the entire process.


3.                  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 usually responsible for corporate strategy and policies that can directly affect the future of the entire firm.

 

Plant and divisional managers are usually paid a fixed salary plus a bonus based on accounting measures of performance.  This is done because they are directly responsible for day-to-day performance and this valuation method provides an absolute standard of performance, as opposed to a standard that is relative to shareholder expectations.  Further, it allows for the evaluation of junior managers who are only responsible for a small segment of the total corporate operation.

 

 

4.                  a.            When paid a fixed salary without incentives to act in shareholders’ best interest, managers often act sub-optimally.

1.                  They may reduce their efforts to find and implement projects that add value.

2.                  They may extract benefits-in-kind from the corporation in the form of a more lavish office, tickets to social events, overspending on expense accounts, etc.

3.                  They may expand the size of the operation just for the prestige of running a larger company

4.                  They may choose second-best investments to reward existing employees rather than the alternative that requires outside personnel but has a higher NPV.

5.                  In order to maintain their comfortable jobs, managers may invest in safer rather than riskier projects.

 

b.                 Tying the manager’s compensation to EVA attempts to ensure that assets are deployed efficiently and that earned returns exceed the cost of capital.  Hence, actions taken by the manager to shirk the duty of maximizing shareholder wealth generally result in a return that does not exceed the minimum required rate of return (cost of capital).  The more the manager works in the interests of the shareholder, the greater the EVA.

 

 

5.                  a.            EVA = Income earned – (Cost of capital x Investment)

                        = $8.03m – (0.09 x $55.4m) = $8.03m - $4.99m = $3.04m

            b.            EVA = $8.03m – (0.09 x $95m) = $8.03m - $8.55m = -$0.52m

                        The market value of the assets should be used to capture the true opportunity cost of capital.

 

 

6.         a.            If a firm announces the hiring of a new manager who is expected to increase the firm’s value, this information should be immediately reflected in the stock price.  If the manager then performs as expected, there should not be much change in the share price since this performance has already been incorporated in the stock value.

 

            b.            This could potentially be a very serious problem since the manager could lose money for reasons out of her control.  One solution might be to index the price changes and then compare the actual raw material price paid with the indexed value.  Another alternative would be to compare the performance with the performance of competitive firms.

 

c.                  It is not necessarily an advantage to have a compensation scheme tied to stock returns.  For example, in addition to the problem of expectations discussed in Part (a), there are numerous factors outside the manager’s control, such as federal monetary policy or new environmental regulations.  However, the stock price does tend to increase or decrease depending on whether the firm does or does not exceed the required cost of capital.  To this extent, it is a measure of performance.

 

7.         EVA = Income earned – (Cost of capital x Investment)

                     = $1.2m – [0.15 x ($4m + $2m + $8m)] = $1.2m - $2.1m = -$0.9m

 

8.                  Agency problems likely to be encountered in capital investment decisions:

§         Reduced effort: Shirking the responsibility of finding and implementing value-added projects.

§         Perks: Exploiting the benefits of the managerial position in order to get benefits from the corporation for personal use.

§         Empire building: Obtaining and running larger operations merely for personal prestige.

§         Entrenching investment: Favoring projects to reward existing managers instead of pursuing higher value-added projects requiring new expertise.

§         Avoiding risk: Choosing safer projects over more risky, higher value-added projects.

 

 

9.                  Security analysts generate business for their own firms based upon the accuracy of their recommendations.  Thus, in looking-out for their own shareholders’ or customers’ interests, they are also working in the best interests of the shareholders of the firms they analyze.  This is particularly true for firms with large numbers of shareholders.  A motivated monitoring agent reduces the free-rider problem by assuming the delegated monitoring duties.  Also, because they are industry experts and are paid by potential investors, the analysts examine the performance of the firm’s capital investment program.  Firms are eager to have more investors since it makes raising capital easier for future projects.

 

10.             Delegated monitoring refers to a group of individuals, usually the Board of Directors and independent outside auditors, who are elected and/or paid to meet with top management in order to determine whether the firm is being operated in a fashion consistent with the best interests of the shareholders.

 

 

11.       a.            False.  The biases rarely wash out.  For example, steady state income may not be much affected by investments in R & D but book asset value is understated.  Thus, book profitability is too high, even in the steady state.

 

            b.            True.  All biases in book profitability can be traced to accounting rules governing which assets are put on the balance sheet and the choice of book depreciation schedules.

 

 

12.       The year-by-year book and economic profitability and rates of return are calculated in the table below.  (We assume straight-line depreciation, $10 per year for years one through ten).

 

Because a plant lasts for 10 years, ‘steady state’ for a mature company implies that we are operating ten plants, and every year we close one and begin construction on another.  The total book income is $76, which is the same as the sum of the Book Income figures from the table (i.e., the sum of -$30, -$22, $16, etc.).  Similarly, the total book investment is $550.  Thus, the steady state book rate of return for a mature company producing Polyzone is: (76/550) = 13.8%.  Note that this is considerably different from the economic rate of return, which is 8 percent.

 

 

t=0

t=1

t=2

t=3

t=4

t=5

t=6

t=7

t=8

t=9

t=10

 

Investment

100

 

 

 

 

 

 

 

 

 

 

 

Depreciation

 

10.0

10.0

10.0

10.0

10.0

10.0

10.0

10.0

10.0

10.0

 

Book Value

 

 

 

 

 

 

 

 

 

 

 

 

   End of Year

 

90.0

80.0

70.0

60.0

50.0

40.0

30.0

20.0

10.0

0.0

 

Net Revenue

0

0.0

38.0

76.0

76.0

76.0

76.0

76.0

76.0

76.0

76.0

 

Production Costs

0

0.0

30.0

30.0

30.0

30.0

30.0

30.0

30.0

30.0

30.0

 

Transport & Other

0

20.0

20.0

20.0

20.0

20.0

20.0

20.0

20.0

20.0

20.0

 

Book Income

0

-30.0

-22.0

16.0

16.0

16.0

16.0

16.0

16.0

16.0

16.0

 

Book Rate of Return

 

-30.0%

-24.4%

20.0%

22.9%

26.7%

32.0%

40.0%

53.3%

80.0%

160.0%

Cash Flow

-100

-20.0

-12.0

26.0

26.0

26.0

26.0

26.0

26.0

26.0

26.0

 

PV at Start of Year

 

99.3

127.2

149.4

135.4

120.2

103.8

86.1

67.0

46.4

24.1

 

PV at End of Year

 

127.2

149.4

135.4

120.2

103.8

86.1

67.0

46.4

24.1

0.0

 

Change in PV

 

27.9

22.2

-14.0

-15.2

-16.4

-17.7

-19.1

-20.6

-22.3

-24.1

 

Economic Depreciation

 

-27.9

-22.2

14.0

15.2

16.4

17.7

19.1

20.6

22.3

24.1

 

Economic Income

 

7.9

10.2

12.0

10.8

9.6

8.3

6.9

5.4

3.7

1.9

 

Economic Rate

       of Return

 

8.0%

8.0%

8.0%

8.0%

8.0%

8.0%

8.0%

8.0%

8.0%

8.0%

 

 

 

13.       a.            See table below.  Straight-line depreciation would be $166.67 per year.  Hence, economic depreciation in this case is accelerated, relative to straight-line depreciation.

 

b.                 The true rate of return is found by dividing economic income by the start-of-period present value.  As stated in the text, this will always be 10 percent.  The book ROI is calculated in Panel B (using straight-line depreciation).

 

A.                Forecasted Economic Income and Rate of Return

 

Year

 

1

2

3

4

5

6

Cash Flow

298.0

298.0

298.0

138.0

138.0

138.0

PV at start of year

998.9

800.8

582.9

343.2

239.5

125.5

PV at end of year

800.8

582.9

343.2

239.5

125.5

0.0

Change in PV

-198.1

-217.9

-239.7

-103.7

-114.0

-125.5

Economic depreciation

198.1

217.9

239.7

103.7

114.0

125.5

Economic return

99.9

80.1

58.3

34.3

24.0

12.5

Rate of return

0.1000

0.1000

0.1000

0.0999

0.1002

0.0996

 

B.                Forecasted Book Income and ROI

 

Year

 

1

2

3

4

5

6

Cash Flow

298.00

298.00

298.00

138.00

138.00

138.00

BV at start of year

1000.00

833.33

666.66

500.00

333.33

166.66

BV at end of year

833.33

666.66

500.00

333.33

166.66

0.00

Change in BV

-166.67

-166.67

-166.66

-166.67

-166.67

-166.66

Book depreciation

166.67

166.67

166.66

166.67

166.67

166.66

Book income

131.33

131.33

131.34

-28.67

-28.67

-28.66

Book ROI

0.1313

0.1576

0.1970

-0.0573

-0.0860

-0.1720

 

 

14.            Internet exercise; answers will vary.


Challenge Questions.

 

 

1.                  The optimal level of agency costs is the point at which the marginal return derived from monitoring top management and ensuring they are working in the best interests of the shareholders equals the marginal cost of any shirking and other acts that do not maximize value.

 

 

2.                  No, there would be no need for EVA.  The problem in managing performance is the difficulty in obtaining economic values for some activities (e.g., the ability to expand production in the future).  As a result, we are left with accounting figures derived from arbitrary rules governing the assets or expenditures that should be put on the balance sheet, and how these assets are treated for deprecation purposes.

 

 

3.                  For a 10 percent expansion in book investment, ROI for Nodhead is given in the table below.  When the steady-state growth rate is exactly equal to the economic rate of return (i.e., 10 percent), the economic rate of return and book ROI are the same.

 

Book Income for

Assets Put in Place

During Year

 

 

1

 

 

2

 

 

3

 

 

4

 

 

5

 

 

6

1

-67

33

83

131

131

131

2

 

-74

36

91

144

144

3

 

 

-81

40

100

159

4

 

 

 

-89

44

110

5

 

 

 

 

-98

48

6

 

 

 

 

 

-108

Total Book Income:

-67

-41

38

173

321

484

 


Book Value for

Assets Put in Place

During Year

 

 

1

 

 

2

 

 

3

 

 

4

 

 

5

 

 

6

1

1000

833

667

500

333

167

2

 

1100

916

734

550

366

3

 

 

1210

1008

807

605

4

 

 

 

1331

1109

888

5

 

 

 

 

1464

1220

6

 

 

 

 

 

1610

Total Book Income:

1000

1933

2793

3573

4263

4856

Book ROI:

-0.067

-0.021

0.014

0.048

0.075

0.100*

               *This is the steady state rate of return.

 

4.        

 

Year 1

Year 2

Year 3

Cash Flow

5.20

4.80

4.40

PV at start of year

12

8

4

PV at end of year

8

4

0

Change in PV

-4

-4

-4

Economic depreciation

4

4

4

Economic income

1.20

0.80

0.40

Economic rate of return

0.10

0.10

0.10

Book depreciation

4

4

4

Book income

1.20

0.80

0.40

Book rate of return

0.10

0.10

0.10


 

 

5.       First calculate present value and economic income of one parlor (figures in thousands):

 

Year 1

Year 2

Year 3

Year 4

Year 5

Cash flow

0

40

80

120

170

PV start of year

200

240

248

218

142

Change in PV

+40

+8

-30

-76

-142

Economic income

+40

+48

+50

+44

+28

Economic return

0.20

0.20

0.20

0.20

0.20

 

            Given that the cost of capital is 20 percent, these parlors are break-even investments; i.e., the rate of return equals the cost of capital (or investing $200,000 buys an asset worth $200,000).  In that case, the rate of expansion is immaterial.  The value of Kipper’s stock should not be affected by the announcement that it intends to make more zero-NPV investments.  If Kipper’s sole asset in 2001 was one parlor, the market value of the common stock should be $200,000.

 

            Now consider what happens to Kipper’s book income and return.  For the first expansion plan:

 

Year 1

Year 2

Year 3

Year 4

Year 5

Number of parlors

1

2

3

4

5

Cash flow

0

40

120

240

410

BV start of year

200

360

480

560

600

Book depreciation

40

80

120

160

200

Book income

-40

-40

0

80

210

Book ROI

-0.20

-0.11

0

0.14

0.35

 

            The steady-state book return of 35 percent is reached in year 5.


 

            For the second expansion plan:

 

Year 1

Year 2

Year 3

Year 4

Year 5

Number of parlors

1

3

6

10

15

Cash flow

0

40

160

400

810

BV start of year

200

560

1040

1600

2200

Book depreciation

40

120

240

400

600

Book income

-40

-80

-80

0

210

Book ROI

-0.20

-0.14

-0.08

0

0.10

 

            By year 5, Kipper’s book profitability has crept up to only 10 percent.  Perhaps this explains the market letter’s change of heart.  Of course, Kipper’s rate of expansion under the second plan must slow down eventually.  The point is that, because economic depreciation is decelerated, more rapid growth in zero-NPV investments hurts book profitability.  It would also reduce earnings per share.  Of course, the rate at which you add zero-NPV investments does not affect economic return or economic earnings per share.  Thus, the market letter has responded to book prospects, not to true value.

 

 

6.         a.         See table on next page.  Note that economic depreciation is simply the change in market value, while book depreciation (per year) is:

 

                                    [19.69 – (0.2 ´ 19.69)]/15 = 1.05

                        Thus, economic depreciation is accelerated in this case, relative to book depreciation.

 

b.                 See table on next page.  Note that the book rate of return exceeds the true rate in only the first year.

 

c.                  Because the economic return from investing in one airplane is 10 percent each year, the economic return from investing in a fixed number per year is also 10 percent each year.  In order to calculate the book return, assume that we invest in one new airplane each year (the number of airplanes does not matter, just so long as it is the same each year).  Then, book income will be (3.67 – 1.05) = 2.62 from the airplane in its first year, (3.00 – 1.95) = 1.95 from the airplane in its second year, etc., for a total book income of 15.21.  Book value is calculated similarly: 19.69 for the airplane just purchased, 18.64 for the airplane that is one year old, etc., for a total book value of 185.10.  Thus, the steady-state book rate of return is 8.22 percent, which understates the true (economic) rate of return (10 percent).


 

 

Year

 

 

1

2

3

4

5

6

7

8

Market value

19.69

17.99

16.79

15.78

14.89

14.09

13.36

12.68

Economic depreciation

 

1.70

1.20

1.01

0.89

0.80

0.73

0.68

Cash flow

 

3.67

3.00

2.69

2.47

2.29

2.14

2.02

Economic income

 

1.97

1.80

1.68

1.58

1.49

1.41

1.34

Economic return

 

10.0%

10.0%

10.0%

10.0%

10.0%

10.0%

10.0%

 

 

 

 

 

 

 

 

 

Book value

19.69

18.64

17.59

16.54

15.49

14.44

13.39

12.34

Book depreciation

 

1.05

1.05

1.05

1.05

1.05

1.05

1.05

Book income

 

2.62

1.95

1.64

1.42

1.24

1.09

0.97

Book return

 

13.3%

10.5%

9.3%

8.6%

8.0%

7.5%

7.2%

 

 

Year

 

 

9

10

11

12

13

14

15

16

Market value

12.05

11.46

10.91

10.39

9.91

9.44

9.01

8.59

Economic depreciation

0.63

0.59

0.55

0.52

0.48

0.47

0.43

0.42

Cash flow

1.90

1.80

1.70

1.61

1.52

1.46

1.37

1.32

Economic income

1.27

1.21

1.15

1.09

1.04

0.99

0.94

0.90

Economic return

10.0%

10.0%

10.0%

10.0%

10.0%

10.0%

10.0%

10.0%

 

 

 

 

 

 

 

 

 

Book value

11.29

10.24

9.19

8.14

7.09

6.04

4.99

3.94

Book depreciation

1.05

1.05

1.05

1.05

1.05

1.05

1.05

1.05

Book income

0.85

0.75

0.65

0.56

0.47

0.41

0.32

0.27

Book return

6.9%

6.6%

6.3%

6.1%

5.8%

5.8%

5.3%

5.4%