Chap012.pdf

Chapter 12 - Agency Problems, Compensation, and Performance Measurement

Chapter 12 Agency Problems, Compensation, and Performance Measurement Multiple Choice Questions

1. In the principal-agent framework, the ultimate principal is: I) Managers; II) Board of directors; III) Shareholders; IV) Government A. I and II only B. IV only C. III only D. I, II and IV only

2. The following are agency problems in capital budgeting except: A. Empire building B. Entrenching investment C. Avoiding risks D. Accepting all the positive NPV projects

3. The following are agency problems associated with capital budgeting except: A. Reduced effort B. Maximizing the value of the firm to the shareholders C. Empire building D. Perks

4. The following are agency problems associated with capital budgeting except: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V

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5. The following capital expenditure(s) are (is) included in the capital budget: A. Investment in information technology B. Investment in research and development C. Investment in training and personal development D. Investment in a new office building

6. Which of the following capital expenditure may not appear in capital budget? I) Investment in a new plant II) Investment in a new machine III) Investment in training employees A. I only B. II only C. III only D. I and II only

7. The following actions by the managers may result in over-investment problem: I) entrenching investments II) empire building III) investing beyond the point where NPV falls zero A. I only B. II only C. I and II only D. I, II, and III 8. Managers on a fixed salary are subjected to following temptations all the time: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V

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9. Agency costs can be thought of as the loss in the value of a firm resulting from the following actions by managers: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V

10. Monitoring is done by: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

11. The ultimate responsibility for monitoring a firm rests with: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

12. In large public companies monitoring is delegated to: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. II only C. I, II, and III only D. I, II, III and IV

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13. Agency costs can be reduced by monitoring: I) managers' efforts II) managers' actions III) by intervening when managers veer off course A. I only B. I and II only C. I, II and III only D. III only

14. Free-rider problem in the case of monitoring results in: I) ineffective monitoring by the shareholders II) monitoring being delegated III) no monitoring by a large number of small individual investors A. I only B. II only C. III only D. I, II and III

15. Because monitoring is not perfect, managers compensation plans must be designed provide them incentives to: A. put in a lot of effort B. work long hours C. take actions that make employees happy D. maximize the value of the firm to the shareholders

16. Generally, mangers' compensation is based on: A. the effort they put in B. the number of hours they work C. verifiable results D. none of the above

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17. CEO compensation is the highest in (the): A. U.S.A. B. India C. U.K. D. Germany

18. When stock options are given to managers as incentives, typically the exercise price of these options is set equal to the firm's: A. stock price on the day the options are granted. B. expected stock price in one year from the day the options are granted. C. expected stock price on the expiration date of the options. D. none of the above.

A firm has an average investment of $1000 during the year. During the same time the firm has an after tax earnings of $150.

19. If the cost of capital is 10%, what is the net return on investment? A. 10% B. 5% C. 12% D. None of the above

20. Calculate the economic value added (EVA) for the firm. (Cost of capital is 10%) A. $100 B. $50 C. $120 D. None of the above

A firm has an average investment of $10,000 during the year. During the same time the firm has an after tax income of $2,000.

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21. If the cost of capital is 15%, what is the net return on the investment? A. 5% B. 20% C. 15% D. None of the above

22. Calculate the economic value added (EVA) for the firm. (Cost of capital is 15%) A. $500 B. $1,500 C. $2,000 D. None of the above

A firm has an average investment of $10,000 during the year. During the same period, the firm has an after-tax income of $1000.

23. If the cost of capital is 15%, what is the net return on the investment? A. 15% B. -5% C. 10% D. None of the above

24. Calculate the economic value added (EVA) for the firm. (Cost of capital is 15%) A. -$500 B. $1500 C. $1200 D. None of the above

25. The term Economic Value Added (EVA) is copyrighted by: A. Brealey-Myers B. Brealey-Myers-Allen C. Ross-Westerfield D. Stern-Stewart

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26. Economic Value Added (EVA) is calculated as follows: A. EVA = Income Earned - (cost of debt) * (investment) B. EVA = Income Earned - (cost of equity) * (investment) C. EVA = Income Earned - (cost of capital) * (investment) D. none of the above

27. A firm has an average investment of 100,000 during the year. During the same period, the firm has an after-tax income of $16,000. If the cost of capital is 15%, what is the economic profit? A. +16,000 B. +15,000 C. +1,000 D. None of the above

28. Economic profit (EP) is calculated as follows: A. EP = (ROI - r) * (capital invested) where r = cost of capital B. EP = (ROI + r) * (capital invested) where r = cost of capital C. EP = (ROI) * (capital invested) D. none of the above

29. The following are disadvantages of using EVA as a measure of performance except: A. EVA does not measure present value B. EVA rewards taking project with quick paybacks and penalizes taking projects with longer payback periods C. EVA reduces explicit monitoring by top management D. EVA is difficult to apply for start up ventures

30. The following are advantages of using EVA as a measure of performance except: A. EVA is a substitute for explicit monitoring by top management B. EVA makes the cost of capital visible to the operating management hence reduce capital employed C. EVA does not measure present value D. EVA highlights the parts of business that are not performing

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31. EVA is used for: I) Measuring performance within the firm II) Rewarding performance within the firm III) Improving performance within the firm A. I only B. II only C. I and II only D. I, II, and III

32. The following firms have positive EVAs except: A. Microsoft B. Pfizer C. Wal-Mart Stores D. Intel Corp.

33. The following firms have negative EVAs except: A. Time Warner B. Pfizer C. IBM D. Coca-Cola

34. The plant manager can improve EVA by: I) increasing earnings II) increasing capital employed III) reducing earnings IV) reducing capital employed A. I and II only B. II and III only C. III and IV only D. I and IV only

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35. Generally, firms with high levels of intangible assets tend to report (with other things being the same): A. Lower than actual ROI B. Higher than actual ROI C. Same as the actual ROI D. None of the above

36. Economic rate of return is defined as: A. [(C1 + PV1 - PV0 )]/(PV0) B. [(C1 - (PV1 - PV0 )]/(PV0) C. [(C1 + PV1)]/(PV0) D. None of the above

Consider an asset with the following cash flows: The firm uses straight-line book depreciation. For this project; it writes off $7 per year in years 1, 2 and 3. The discount rate is 10%.

37. Calculate the economic depreciation in years 1, 2 and 3. A. 7, 7, 7 B. 9, 7, 5 C. 10, 7, 3 D. None of the above

38. Calculate the economic income in years 1, 2 and 3. A. 2.1, 1.4, 0.7 B. 7, 7, 7 C. 1.0, 7.1, 3.7 D. None of the above

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39. Calculate the economic rate of return in years 1, 2 and 3. A. 43.3%, 43.3%, 65% B. 10%, 10%, 10% C. 43.3%, 40%, 36.7% D. None of the above

40. According to the survey of senior managers by Graham, Harvey and Rajgopal, the senior managers admitted to the following: I) adjusting their firms' operations and investments in order to manage earnings. II) they were willing to decrease discretionary spending in R&D, advertising or maintenance if necessary to meet earnings target. III) many of them would, if necessary, also defer or reject investment projects with positive NPVs. A. I only B. II only C. I and II only D. I, II, and III

41. A firm produces $65 million of net income on $2,030 million of assets. Given that investors expect a 5% return, what is the economic profit? A. -$65.0 million B. -$36.5 million C. $32.6 million D. $65.1 million

42. A firm produces $124 million of net income on $1,600 million of assets. Through a six sigma project, the firm is able to the assets employed to $1,450 million. Given a 5% cost of capital, what is the increase in the EVA? A. $7.5 million B. $44.0 million C. $51.5 million D. $96.5 million

True / False Questions

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43. Top management, using computers, generally analyzes all the capital budgeting projects every year before deciding on them. True False

44. Agency problems in capital budgeting include—reduced efforts, perks, empire building and entrenching investments. True False

45. Monitoring generally reduces agency costs. True False

46. CEOs of U.S. companies receive the highest level of compensation in terms of long-term incentives and variable bonuses. True False

47. EVA = Income Earned - (Cost of capital) * (Investment). True False

48. EVA can easily be applied to R&D programs and startup ventures. True False

49. Economic Profit = EP = (ROI - r)(capital invested). True False

50. Economic Income = cash flow - economic depreciation. True False

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51. Economic Value Added is a new concept recently introduced into finance. True False

52. Economic profit can be increased by reducing assets employed.

True False

Short Answer Questions

53. What are some of the agency problems associated with capital budgeting?

54. Briefly explain the term "qualified opinion" issued by the auditors.

55. Define the term "Economic Value Added (EVA)."

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56. Define the term "Net earnings."

57. Briefly explain how a plant manager can improve EVA (Economic Value Added)?

58. Define the term "economic rate of return."

59. Define the term "Economic Income."

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60. Why can the financial success of a movie not be easily evaluated using EVA?

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Chapter 12 Agency Problems, Compensation, and Performance Measurement Answer Key

Multiple Choice Questions

1. In the principal-agent framework, the ultimate principal is: I) Managers; II) Board of directors; III) Shareholders; IV) Government A. I and II only B. IV only C. III only D. I, II and IV only

Type: Easy

2. The following are agency problems in capital budgeting except: A. Empire building B. Entrenching investment C. Avoiding risks D. Accepting all the positive NPV projects

Type: Medium

3. The following are agency problems associated with capital budgeting except: A. Reduced effort B. Maximizing the value of the firm to the shareholders C. Empire building D. Perks

Type: Medium

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4. The following are agency problems associated with capital budgeting except: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V

Type: Difficult

5. The following capital expenditure(s) are (is) included in the capital budget: A. Investment in information technology B. Investment in research and development C. Investment in training and personal development D. Investment in a new office building

Type: Medium

6. Which of the following capital expenditure may not appear in capital budget? I) Investment in a new plant II) Investment in a new machine III) Investment in training employees A. I only B. II only C. III only D. I and II only

Type: Medium

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7. The following actions by the managers may result in over-investment problem: I) entrenching investments II) empire building III) investing beyond the point where NPV falls zero A. I only B. II only C. I and II only D. I, II, and III

Type: Medium

8. Managers on a fixed salary are subjected to following temptations all the time: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V Type: Difficult

9. Agency costs can be thought of as the loss in the value of a firm resulting from the following actions by managers: I) reduced effort II) perks or private benefits III) empire building IV) entrenching investments V) avoiding risks A. I, II and V only B. I, II, and IV only C. I, II, III and IV only D. I, II, III, IV and V

Type: Difficult

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10. Monitoring is done by: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

Type: Medium

11. The ultimate responsibility for monitoring a firm rests with: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

Type: Medium

12. In large public companies monitoring is delegated to: I) Shareholders; II) Board of Directors; III) Independent accountants; IV) Lenders A. I only B. II only C. I, II, and III only D. I, II, III and IV

Type: Medium

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13. Agency costs can be reduced by monitoring: I) managers' efforts II) managers' actions III) by intervening when managers veer off course A. I only B. I and II only C. I, II and III only D. III only

Type: Easy

14. Free-rider problem in the case of monitoring results in: I) ineffective monitoring by the shareholders II) monitoring being delegated III) no monitoring by a large number of small individual investors A. I only B. II only C. III only D. I, II and III

Type: Medium

15. Because monitoring is not perfect, managers compensation plans must be designed provide them incentives to: A. put in a lot of effort B. work long hours C. take actions that make employees happy D. maximize the value of the firm to the shareholders

Type: Medium

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16. Generally, mangers' compensation is based on: A. the effort they put in B. the number of hours they work C. verifiable results D. none of the above

Type: Easy

17. CEO compensation is the highest in (the): A. U.S.A. B. India C. U.K. D. Germany

Type: Easy

18. When stock options are given to managers as incentives, typically the exercise price of these options is set equal to the firm's: A. stock price on the day the options are granted. B. expected stock price in one year from the day the options are granted. C. expected stock price on the expiration date of the options. D. none of the above.

Type: Medium

A firm has an average investment of $1000 during the year. During the same time the firm has an after tax earnings of $150.

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19. If the cost of capital is 10%, what is the net return on investment? A. 10% B. 5% C. 12% D. None of the above (150/1000) - 0.10=0.05 = 5%

Type: Medium

20. Calculate the economic value added (EVA) for the firm. (Cost of capital is 10%) A. $100 B. $50 C. $120 D. None of the above EVA = 150 - (0.10)(1000) = $50

Type: Medium

A firm has an average investment of $10,000 during the year. During the same time the firm has an after tax income of $2,000.

21. If the cost of capital is 15%, what is the net return on the investment? A. 5% B. 20% C. 15% D. None of the above (2,000/10,000) - 0.15 = 0.05 = 5%

Type: Medium

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22. Calculate the economic value added (EVA) for the firm. (Cost of capital is 15%) A. $500 B. $1,500 C. $2,000 D. None of the above EVA = 2000 - (0.15)(10,000) =$500

Type: Medium

A firm has an average investment of $10,000 during the year. During the same period, the firm has an after-tax income of $1000.

23. If the cost of capital is 15%, what is the net return on the investment? A. 15% B. -5% C. 10% D. None of the above Net return on investment = 1000/10000 - 0.15 = - 0.05 or - 5%

Type: Medium

24. Calculate the economic value added (EVA) for the firm. (Cost of capital is 15%) A. -$500 B. $1500 C. $1200 D. None of the above EVA = 1000 - (0.15)(10,000)= - 500;

Type: Medium

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25. The term Economic Value Added (EVA) is copyrighted by: A. Brealey-Myers B. Brealey-Myers-Allen C. Ross-Westerfield D. Stern-Stewart

Type: Easy

26. Economic Value Added (EVA) is calculated as follows: A. EVA = Income Earned - (cost of debt) * (investment) B. EVA = Income Earned - (cost of equity) * (investment) C. EVA = Income Earned - (cost of capital) * (investment) D. none of the above

Type: Medium

27. A firm has an average investment of 100,000 during the year. During the same period, the firm has an after-tax income of $16,000. If the cost of capital is 15%, what is the economic profit? A. +16,000 B. +15,000 C. +1,000 D. None of the above ROI = 16,000/100,000 = 0.16; economic profit = (0.16 - 0.15)(100,000)= 1,000

Type: Medium

28. Economic profit (EP) is calculated as follows: A. EP = (ROI - r) * (capital invested) where r = cost of capital B. EP = (ROI + r) * (capital invested) where r = cost of capital C. EP = (ROI) * (capital invested) D. none of the above

Type: Medium

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29. The following are disadvantages of using EVA as a measure of performance except: A. EVA does not measure present value B. EVA rewards taking project with quick paybacks and penalizes taking projects with longer payback periods C. EVA reduces explicit monitoring by top management D. EVA is difficult to apply for start up ventures

Type: Medium

30. The following are advantages of using EVA as a measure of performance except: A. EVA is a substitute for explicit monitoring by top management B. EVA makes the cost of capital visible to the operating management hence reduce capital employed C. EVA does not measure present value D. EVA highlights the parts of business that are not performing

Type: Medium

31. EVA is used for: I) Measuring performance within the firm II) Rewarding performance within the firm III) Improving performance within the firm A. I only B. II only C. I and II only D. I, II, and III

Type: Medium

32. The following firms have positive EVAs except: A. Microsoft B. Pfizer C. Wal-Mart Stores D. Intel Corp.

Type: Easy

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33. The following firms have negative EVAs except: A. Time Warner B. Pfizer C. IBM D. Coca-Cola

Type: Easy

34. The plant manager can improve EVA by: I) increasing earnings II) increasing capital employed III) reducing earnings IV) reducing capital employed A. I and II only B. II and III only C. III and IV only D. I and IV only

Type: Difficult

35. Generally, firms with high levels of intangible assets tend to report (with other things being the same): A. Lower than actual ROI B. Higher than actual ROI C. Same as the actual ROI D. None of the above

Type: Easy

36. Economic rate of return is defined as: A. [(C1 + PV1 - PV0 )]/(PV0) B. [(C1 - (PV1 - PV0 )]/(PV0) C. [(C1 + PV1)]/(PV0) D. None of the above

Type: Medium

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Consider an asset with the following cash flows: The firm uses straight-line book depreciation. For this project; it writes off $7 per year in years 1, 2 and 3. The discount rate is 10%.

37. Calculate the economic depreciation in years 1, 2 and 3. A. 7, 7, 7 B. 9, 7, 5 C. 10, 7, 3 D. None of the above Economic depreciation = change in PV = 7

Type: Difficult

38. Calculate the economic income in years 1, 2 and 3. A. 2.1, 1.4, 0.7 B. 7, 7, 7 C. 1.0, 7.1, 3.7 D. None of the above Economic depreciation = change in PV = 7 Year 1: Economic income = cash flow - economic depreciation = 9.1 =2.1; Year 2: 8.4 7=1.4; Year 3: 7.7 - 7=0.7

Type: Difficult

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39. Calculate the economic rate of return in years 1, 2 and 3. A. 43.3%, 43.3%, 65% B. 10%, 10%, 10% C. 43.3%, 40%, 36.7% D. None of the above Economic rate of return = Cash flow change in PV/initial PV; PV0 = 21, PV1=14 & PV2 = 7 Year 1: Economic rate of return: = (9.1 - 7)/21= 10%; Year 2: (8.4 - 7)/14=10% Year 3: (7.7 7)/7=10%

Type: Difficult

40. According to the survey of senior managers by Graham, Harvey and Rajgopal, the senior managers admitted to the following: I) adjusting their firms' operations and investments in order to manage earnings. II) they were willing to decrease discretionary spending in R&D, advertising or maintenance if necessary to meet earnings target. III) many of them would, if necessary, also defer or reject investment projects with positive NPVs. A. I only B. II only C. I and II only D. I, II, and III

Type: Difficult

41. A firm produces $65 million of net income on $2,030 million of assets. Given that investors expect a 5% return, what is the economic profit? A. -$65.0 million B. -$36.5 million C. $32.6 million D. $65.1 million 65/2030 = .032 EP = (.032 - .05) × 2030 = -36.5

Type: Difficult

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42. A firm produces $124 million of net income on $1,600 million of assets. Through a six sigma project, the firm is able to the assets employed to $1,450 million. Given a 5% cost of capital, what is the increase in the EVA? A. $7.5 million B. $44.0 million C. $51.5 million D. $96.5 million EVA1 = 124 - (.05 × 1600) = 44; EVA 2 = 124 - (.05 × 1450) = 51.5 Increase in EVA = 51.5 - 44 = 7.5

Type: Difficult

True / False Questions

43. Top management, using computers, generally analyzes all the capital budgeting projects every year before deciding on them. FALSE

Type: Medium

44. Agency problems in capital budgeting include—reduced efforts, perks, empire building and entrenching investments. TRUE

Type: Easy

45. Monitoring generally reduces agency costs. TRUE

Type: Easy

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46. CEOs of U.S. companies receive the highest level of compensation in terms of long-term incentives and variable bonuses. TRUE

Type: Easy

47. EVA = Income Earned - (Cost of capital) * (Investment). TRUE

Type: Medium

48. EVA can easily be applied to R&D programs and startup ventures. FALSE

Type: Difficult

49. Economic Profit = EP = (ROI - r)(capital invested). TRUE

Type: Medium

50. Economic Income = cash flow - economic depreciation. TRUE

Type: Medium

51. Economic Value Added is a new concept recently introduced into finance. FALSE

Type: Medium

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52. Economic profit can be increased by reducing assets employed.

TRUE

Type: Medium

Short Answer Questions

53. What are some of the agency problems associated with capital budgeting? Some of the agency problems encountered in capital budgeting are: • Reduced effort • Perks • Empire building • Entrenching investment • Avoiding risks

Type: Medium

54. Briefly explain the term "qualified opinion" issued by the auditors. When independent auditors find problems associated with the accounting procedures of a firm they issue a "qualified opinion." A qualified opinion is bad news for the company as it suggests that the firm is not following proper accounting procedures.

Type: Easy

55. Define the term "Economic Value Added (EVA)." Economic Value added is defined as income earned by a firm minus the capital costs. EVA measures the additional wealth created in dollar terms.

Type: Easy

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56. Define the term "Net earnings." Net earnings are earnings after taxes but without taking into account interest payments.

Type: Medium

57. Briefly explain how a plant manager can improve EVA (Economic Value Added)? Generally, EVA makes the cost of capital more visible to the plant managers. They can improve the EVA of their division by (a) increasing earnings or (b) reducing capital employed or both.

Type: Medium

58. Define the term "economic rate of return." Economic rate of return is defined as: cash flow plus change in value divided by initial value.

Type: Easy

59. Define the term "Economic Income." Economic income is defined as the cash flow plus the change in the present value of a firm. It can be thought of as cash flow minus economic depreciation.

Type: Easy

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60. Why can the financial success of a movie not be easily evaluated using EVA? The EVA of a movie is very likely to be positive, while the NPV may very well be negative. Unfortunately, a movie has a very short life span. If a movie generates a 20% ROI in 4 weeks of running and then produces nothing else, it will likely show a positive EVA but still lose money for the investors. Short lived projects are not suitable to be evaluated using EVA.

Type: Difficult

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Chap012.pdf

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