Deck 12: Agency Problems Compensation and Performance Measurement

Question 1

CEO compensation is generally highest in

A)the United States.
B)India.
C)the UK.
D)Germany.

Answer 1

the United States.

Question 2

The following are agency problems associated with capital budgeting except

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

Answer 2

maximizing firm value.

Question 3

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 percent, what is the net return on investment?

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

Answer 3

5 percent

Question 4

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.

Question 5

The ultimate responsibility for monitoring a firm rests with the

A)shareholders only.
B)shareholders and board of directors.
C)shareholders, board of directors, and independent accountants.
D)shareholders, board of directors, independent accountants, and lenders.

Question 6

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

A)shareholders only.
B)board of directors only.
C)shareholders, board of directors, and independent accountants.
D)shareholders, board of directors, independent accountants, and lenders.

Question 7

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 8

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.

Question 9

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 10

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 percent.)

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

Question 11

Monitoring is typically done by

A)shareholders only.
B)shareholders and the board of directors.
C)shareholders, the board of directors, and independent accountants.
D)shareholders, the board of directors, independent accountants, and lenders.

Question 12

The following are agency problems associated with capital budgeting:

A)reduced effort, perks or private benefits, and avoiding risks.
B)reduced effort, perks or private benefits, and entrenching investments.
C)reduced effort, perks or private benefits, empire building, and entrenching investments.
D)reduced effort, perks or private benefits, empire building, entrenching investments, and avoiding risks.

Question 13

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 14

The free-rider problem, when referring to monitoring of firms' performance, often results in

A)ineffective monitoring by the shareholders.
B)monitoring being delegated by shareholders toboards of directors.
C)no monitoring by a large number of small individual investors.
D)ineffective monitoring by the shareholders, monitoring being delegated by shareholders to boards of directors, and no monitoring by a large number of small individual investors.

Question 15

Managers on a fixed salary often fall victim to the following temptations:

A)reduced effort, needless spending on perks or private benefits, and avoiding risks.
B)reduced effort, needless spending on perks or private benefits, and entrenching investments.
C)reduced effort, needless spending on perks or private benefits, empire building, and entrenching investments.
D)reduced effort, needless spending on perks or private benefits, empire building, entrenching investments, and avoiding risks.

Question 16

Agency costs can be reduced by

A)monitoring managers' efforts only.
B)monitoring managers' efforts and managers' actions.
C)monitoring managers' efforts, monitoring managers' actions, and intervening when managers veer off-course.
D)intervening when managers veer off-course.

Question 17

In the principal-agent framework, the ultimate principals are

A)managers and a board of directors only.
B)governments only.
C)shareholders only.
D)managers, a board of directors, and shareholders.

Question 18

Which of the following capital expenditures may not appear in a firm's capital budget?

A)Investment in a new factory only
B)Investment in a new machine only
C)Investment in training employees only
D)Investment in a new factory and in a new machine

Question 19

Agency costs can be thought of as the loss in the value of a firm resulting from the following actions by managers:

A)reduced effort, perks or private benefits, and avoiding risks.
B)reduced effort, perks or private benefits, and entrenching investments.
C)reduced effort, perks or private benefits, empire building, and entrenching investments.
D)reduced effort, perks or private benefits, empire building, entrenching investments, and avoiding risks.

Question 20

The following actions by managers are examples of overinvestment:

A)entrenching investments.
B)empire building.
C)entrenching investments and empire building.
D)entrenching investments, empire building, and investing beyond the point where NPV falls to zero.

Question 21

A factory manager can improve EVA by

A)increasing earnings and increasing capital employed.
B)increasing capital employed and reducing earnings.
C)reducing earnings and reducing capital employed.
D)increasing earnings and reducing capital employed.

Question 22

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 23

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 24

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)the same as the actual ROI on their financial statements.
D)No general relation exists.

Question 25

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 percent.)

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

Question 26

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 percent.)

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

Question 27

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 28

Which of the following statements is not true?

A)EVA is inconsistent with DCF.
B)EVA can be used deep down in the organization and is therefore a substitute for explicit monitoring by top management.
C)Since accounting depreciation often overstates economic depreciation in a project's early years, EVA favors quick-payback projects.
D)None of the options.

Question 29

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 30

According to the survey of senior managers by Graham, Harvey, and Rajgopal, senior managers admitted to the following:

A)adjusting their firms' operations and investments in order to manage earnings.
B)decreasing discretionary spending in R&D, advertising, or maintenance to meet earnings targets.
C)adjusting their firms' operations and investments in order to manage earnings and decreasing discretionary spending in R&D, advertising, or maintenance to meet earnings targets.
D)adjusting their firms' operations and investments in order to manage earnings; decreasing discretionary spending in R&D, advertising, or maintenance to meet earnings target; and deferring or rejecting investment projects with positive NPVs in order to meet earnings targets.

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

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 33

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 percent, what is the net return on the investment?

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

Question 34

The term economic value added (EVA) is trademarked by

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

Question 35

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 percent, what is the net return on the investment?

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

Question 36

One calculates EVA as follows:

A)EVA = (ROI - r) × (capital invested), where r = cost of capital.
B)EVA = (ROI + r) × (capital invested), where r = cost of capital.
C)EVA = (ROI) × (capital invested).
D)EVA = (ROI)/(capital invested).

Question 37

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 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

EVA is used for

A)measuring performance within the firm.
B)rewarding performance within the firm.
C)measuring performance and rewarding performance within the firm.
D)measuring performance within the firm, rewarding performance within the firm, and improving performance within the firm.

Question 40

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 percent, what is the EVA?

A)+$16,000
B)+$15,000
C)+$1,000
D)-$1,000

Question 41

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

Question 42

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

Question 43

EVA can be increased by reducing assets employed.

Question 44

EVA = (ROI - r)(capital invested).

Question 45

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

Question 46

Top management generally use spreadsheet programs to analyze 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

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

Question 49

Survey data show that managers admit to managing earnings.

Question 50

Economic income = cash flow - economic depreciation.

Question 51

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

Question 52

If a company is underperforming, small shareholders will generally start a proxy contest.

Question 53

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

Question 54

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

Question 55

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

Question 56

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

Question 57

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

Question 58

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

Question 59

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 percent cost of capital, what is the increase in the EVA?

A)$7.5 million
B)$44 million
C)$51.5 million
D)$96.5 million

Question 60

A firm produces $65 million of net income on $2,030 million of assets.Given that investors expect a 5 percent return, what is the EVA?

A)-$65 million
B)-$36.5 million
C)$32.6 million
D)$65.1 million

Question 61

Define the term economic value added (EVA).

Question 62

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

Question 63

Boards of directors outside the United States have traditionally been friendlier towards their own managers.

Question 64

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

Question 65

Define the term economic rate of return.

Question 66

Briefly explain the term qualified opinion issued by the auditors.

Question 67

Define the term economic income.