Deck 12: Agency Problems, Compensation, and Performance Measurement

Question 1

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

Answer 1

III only

Question 2

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

Answer 2

Investment in a new office building

Question 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

Answer 3

Maximizing the value of the firm to the shareholders

Question 4

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 5

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

Question 6

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

Question 7

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

Question 8

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

Question 9

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

Question 10

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

Question 11

CEO compensation is the highest in (the):

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

Question 12

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.

Question 13

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

Question 14

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

Question 15

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

Question 16

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

Question 17

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

Question 18

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

Question 19

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

Question 20

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

Question 21

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

Question 22

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

Question 23

The following firms have negative EVAs except:

A) Time Warner
B) Pfizer
C) IBM
D) Coca-Cola

Question 24

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

Question 25

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

Question 26

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

Question 27

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

Question 28

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

Question 29

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

Question 30

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

Question 31

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

Question 32

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

Question 33

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

Question 34

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

Question 35

The term Economic Value Added (EVA) is copyrighted by:

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

Question 36

The following firms have positive EVAs except:

A) Microsoft
B) Pfizer
C) Wal-Mart Stores
D) Intel Corp.

Question 37

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

Question 38

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

Question 39

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 40

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

Question 41

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

Question 42

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

Question 43

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

Question 44

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

Question 45

Define the term "economic rate of return."

Question 46

Define the term "Economic Income."

Question 47

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

Question 48

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

Question 49

Economic Income = cash flow - economic depreciation.

Question 50

Economic profit can be increased by reducing assets employed.

Question 51

Define the term "Net earnings."

Question 52

Monitoring generally reduces agency costs.

Question 53

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

Question 54

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

Question 55

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

Question 56

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

Question 57

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

Question 58

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

Question 59

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

Question 60

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