Deck 12: Agency Problems, Compensation, and Performance Measurement

Question 1

Generally,firms should attempt to base mangers' compensation on:

A)the number of years of managerial experience.
B)the number of hours they work.
C)verifiable results.
D)perks consumed.

Answer 1

verifiable results.

Question 2

The following actions by managers are examples of overinvestment:
i.entrenching investments; II)empire building; III)investing beyond the point where NPV falls to zero

A)I only
B)II only
C)I and II only
D)I,II,and III

Answer 2

I,II,and III

Question 3

Since monitoring is not perfect,compensation plans should primarily provide managers incentives to:

A)put a lot of thought into their work.
B)work long hours.
C)take actions that make stakeholders happy.
D)maximize the value of the firm to the shareholders.

Answer 3

maximize the value of the firm to the shareholders.

Question 4

The following are agency problems associated with capital budgeting:
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

Question 5

Which of the following capital expenditures may not appear in a firm's capital budget?
i.investment in a new factory; 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

Question 6

Agency costs can be reduced by:
i.monitoring managers' efforts; II)monitoring managers' actions; III)intervening when managers veer off-course

A)I only
B)I and II only
C)I,II,and III only
D)III only

Question 7

When firms award stock options to managers as incentives,they typically set the exercise price of these options equal to the firm's:

A)stock price on the day the options are granted.
B)expected stock price one year from the day the options are granted.
C)expected stock price on the expiration date of the options.
D)stock price on the day the manager was hired.

Question 8

The following capital expenditures are typically included in a firm's capital budget:

A)investments in information technology software.
B)investments in research and development.
C)investments in training and personnel development.
D)investments in a new office building.

Question 9

The following are agency problems in capital budgeting except:

A)empire building.
B)entrenching investments.
C)avoiding risks.
D)accepting all positive NPV projects.

Question 10

In the principal-agent framework,the ultimate principals are:
i.managers; II)board of directors; III)shareholders; IV)governments

A)I and II only
B)IV only
C)III only
D)I,II,and III only

Question 11

In large public companies monitoring is the primary responsibility of the:
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

Question 12

A firm has an average investment of $1,000 during the year.During the same time,the firm generates after-tax earnings of $150.
If the cost of capital is 10%,what is the net return on investment?

A)10%
B)5%
C)12%
D)15%

Question 13

Monitoring is typically 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

Question 14

CEO compensation is generally highest in (the):

A)U.S.
B)India.
C)U.K.
D)Germany.

Question 15

The following are agency problems associated with capital budgeting except:

A)reduced effort.
B)maximizing firm value.
C)empire building.
D)perks.

Question 16

The free-rider problem,when referring to monitoring of the firms' performance,often results in:
I.ineffective monitoring by the shareholders;
II.monitoring being delegated by shareholders to boards of directors;
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

Question 17

Managers on a fixed salary often fall victim to the following temptations:
i.reduced effort; II)needless spending on 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

Question 18

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

Question 19

The ultimate responsibility for monitoring a firm rests with the:
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

Question 20

A firm has an average investment of $1,000 during the year.During the same time,the firm generates after-tax earnings of $150.
Calculate the economic value added (EVA)for the firm.(The cost of capital is 10%.)

A)$100
B)$50
C)$120
D)$150

Question 21

The following are disadvantages of using EVA as a performance measure EXCEPT:

A)EVA does not measure present values.
B)EVA rewards the choice of projects with quick paybacks and penalizes projects with longer payback periods.
C)EVA reduces explicit monitoring by top management.
D)EVA is difficult to apply to start-up ventures.

Question 22

The term economic value added (EVA)is copyrighted by:

A)Brealey-Myers.
B)Brealey-Myers-Allen.
C)Ross-Westerfield.
D)Stern-Stewart.

Question 23

The following are advantages of using EVA as a performance measure EXCEPT:

A)EVA can substitute for explicit monitoring by top management.
B)EVA makes the cost of capital visible to operating management,thereby reducing capital employed.
C)EVA does not measure present values.
D)EVA highlights business units that are underperforming their peers.

Question 24

Which of the following actions-all else equal-will increase a firm's EVA?

A)The firm raises its prices,but ships the same amount of product.
B)The firm increases its inventory.
C)The firm increases its borrowing to repurchase some of its shares.
D)The firm increases its accounts receivable.

Question 25

A firm has an average investment of $10,000 during the year.During the same period,the firm generates after-tax income of $1,000.
If the cost of capital is 15%,what is the net return on the investment?

A)15%
B)-5%
C)10%
D)5%

Question 26

According to the survey of senior managers by Graham,Harvey,and Rajgopal,senior managers admitted to the following:
I.adjusting their firms' operations and investments in order to manage earnings;
II.decreasing discretionary spending in R&D,advertising,or maintenance to meet earnings targets;
III.deferring or rejecting investment projects with positive NPVs in order to meet earnings targets

A)I only
B)II only
C)I and II only
D)I,II,and III

Question 27

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

Question 28

The economic rate of return on an asset is defined as:

A)[(C₁ + PV₁ - PV₀)]/(PV₀)
B)[(C₁ - (PV₁ - PV₀)]/(PV₀)
C)[(C₁ + PV₁)]/(PV₀)
D)[(C₁ + PV₀)]/(PV₁)

Question 29

A firm has an average investment of $10,000 during the year.During the same time,the firm generates after-tax income of $2,000.
If the cost of capital is 15%,what is the net return on the investment?

A)5%
B)20%
C)15%
D)10%

Question 30

Which of the following actions-all else equal-will decrease a firm's EVA?

A)The firm raises its prices,but ships the same amount of product.
B)The firm reduces its inventory.
C)The firm increases its borrowing to repurchase some of its shares.
D)The firm increases its accounts receivable.

Question 31

Which type of situation best represents "gambling for redemption"?

A)A manager decides to invest in a single new product instead of three different products.
B)A firm risks its reputation on the introduction of a revolutionary product.
C)The firm's treasurer invests all of its cash in a single money market mutual fund.
D)A firm on the verge of bankruptcy invests all available funds in a high-risk,low-NPV project in order to attempt to save itself.

Question 32

A firm has an average investment of $10,000 during the year.During the same time,the firm generates after-tax income of $2,000.
Calculate the economic value added (EVA)for the firm.(The cost of capital is 15%.)

A)$500
B)$1,500
C)$2,000
D)$1,000

Question 33

Which of the following is NOT an advantage to calculating and reporting economic depreciation?

A)Most firms can easily calculate economic depreciation.
B)Economic depreciation is generally more realistic than accounting depreciation.
C)Economic depreciation enables a firm to understand the true value of its assets.
D)All of the options are advantages to calculating and reporting economic depreciation.

Question 34

One calculates economic profit (EP)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)EP = (ROI)/(capital invested)

Question 35

A firm has an average investment of $100,000 during the year.During the same period,the firm generates 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)-$1,000

Question 36

One calculates economic value added (EVA)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)EVA = income earned - (investment)× (cost of capital)

Question 37

A firm has an average investment of $10,000 during the year.During the same period,the firm generates after-tax income of $1,000.
Calculate the economic value added (EVA)for the firm.(The cost of capital is 15%.)

A)-$500
B)$1,500
C)$1,200
D)$1,000

Question 38

Which of the following is the most likely example of bias in a firm's accounting profitability measures?

A)A manufacturing firm increases its cash holdings.
B)A pharmaceutical firm increases its holdings of finished goods inventory.
C)A bank increases its holding of marketable securities.
D)A consulting firm launches a new policy to pay for MBA education for its midlevel managers.

Question 39

A factory 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

Question 40

Generally,firms with high levels of intangible assets tend to report (all else equal):

A)lower than actual ROI on their financial statements.
B)higher than actual ROI on their financial statements.
C)same as the actual ROI on their financial statements.
D)no general relation exists.

Question 41

EVA = income earned - (cost of capital)× (investment).

Question 42

The main idea behind EVA is a new concept recently introduced into finance.

Question 43

Economic profit can be increased by reducing assets employed.

Question 44

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 million65/2030 = .032.

Question 45

Stock option grants are generally a more appropriate form of compensation for lower-level managers than for higher-level managers.

Question 46

Top management,using computers,generally analyzes all capital budgeting projects before deciding on them.

Question 47

Agency problems in capital budgeting include: reduced effort,perks,empire building,and entrenching investments.

Question 48

Survey data show that managers admit to managing earnings.

Question 49

A firm produces $124 million of net income on $1,600 million of assets.Through a six-sigma project,the firm is able to decrease 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

Question 50

All else equal,one would expect to see more earnings management at privately held corporations than at publicly traded corporations.

Question 51

Economic income = cash flow - economic depreciation.

Question 52

An advantage of stock-based performance compensation for managers is that such managers must bear macroeconomic risks.

Question 53

Economic profit = EP = (ROI - r)(capital invested).

Question 54

Accounting income takes no account of the cost of the capital employed by a firm.

Question 55

One should expect the free-rider problem to be less severe for firms having a higher percentage of intangible assets.

Question 56

In the U.S.,tax advantages exist to compensating good performance by large-firm CEOs with stock option grants rather than by simply increasing salaries.

Question 57

An example of an entrenching investment is a manager that expands the scope of his or her operation.

Question 58

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

Question 59

It is easy to apply EVA to R&D programs and start-up ventures.

Question 60

Shareholders typically rely on independent auditors to monitor the performance of their managers.

Question 61

Define the term economic rate of return.

Question 62

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

Question 63

Briefly explain the term qualified opinion issued by the auditors.

Question 64

Boards of directors outside the U.S.are generally friendlier towards their own managers.

Question 65

Define the term economic value added (EVA).

Question 66

Define the term economic income.

Question 67

Briefly explain how a plant manager can improve EVA (economic value added)?