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., 2000
12- 2
Topics Covered
 The capital investment process
 Decision Makers and Information
 Incentives
 Residual Income and EVA
 Accounting Performance Measures
 Economic Profit
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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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Information Problems
The correct
information
is …
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1. Consistent Forecasts
2. Reducing Forecast Bias
3. Getting Senior Management
Needed Information
4. Eliminating Conflicts of
Interest
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12- 7
Growth and Returns
Rate of return, %
12
11
Economic rate of return
10
9
8
7
5
Irwin/McGraw Hill
10
15
20
25
Rate of
growth,
%
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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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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.
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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.
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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
$1,000
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12- 13
Residual Income & EVA
Quayle City Subduction Plant ($mil)
130
ROI 
 .13
1,000
Given COC = 10%
NetROI  13%  10%  3%
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12- 14
Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital.
 Income Earned - Cost of Capital  Investment

 Income Earned - income required
EVA  Residual Income
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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12- 15
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Given COC = 12%
 $10million
 130  (.12  1,000)
EVA  Residual Income
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12- 16
Economic Profit
Economic Profit = capital invested
multiplied by the spread between return on
investment and the cost of capital.
 ( ROI  r )  Capital Invested
EP  Economic Profit
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Irwin/McGraw Hill
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12- 17
Economic Profit
Quayle City Subduction Plant ($mil)
Example at 12% COC continued.
 $10million
 (.13 - .12)  1,000
EP  ( ROI  r )  Capital Invested
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
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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.
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12- 19
EVA of US firms - 1997
$ in millions)
EVA
Coca Cola
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Capital
Return on Cost of
Invested Capital
Capital
$2,442 $10,814
36.0%
9.7%
Dow Chemical
6,81
23,024
12.2
9 .0
Ford Motor
1,719
58,272
12.1
9.1
General Electric
2,515
53,567
17.7
12.7
General Motors - 3,527
82,887
5.9
9 .7
Hewlett - Packard
- 99
24,185
15.2
15.7
IBM
- 2,743
67,431
7.8
11.8
Johnson & Johnson
1,327
18,138
21.8
13.3
Merck
1,688
22,219
23.0
14.5
Microsoft
1,727
5,680
47.1
11.8
Philip Morris
3,119
42,885
20.1
12.5
Safeway
335
4,963
15.7
8 .5
UAL
298
13,420
9 .8
7 .2
Walt Disne y
- 347
30,702
11.0
12.6
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12- 20
Accounting Measurements
cash receipts  change in price
Rate of return 
beginning price
C1  ( P1  P0 )

P0
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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
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12- 22
Accounting Measurements
INCOME
RETURN
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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
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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
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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
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