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Unformatted text preview: CHAPTER 12 Agency Problems, Management Compensation, and the Measurement of Performance Answers to Practice Questions 1. 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. 2. 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. 104 3. 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 in order 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....
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- Net Present Value, Internal rate of return