Seminar questions week 2

Bouwens & Kroos (2019)

1. What is the decision that is focal in this study and how is the delegation of decision
rights organized in this setting?

The focal decision is about approving a loan or not.

The delegation of decision rights is described as follows:

Lower-level agents collect private information about the quality of borrowers and most of the
time have the authority to approve the loan or not.

However, if the desired loan is riskier or larger, formal approval from higher-level agents is
required.

2. What kind of customers are served in this bank and why is this relevant?

The customers are small businesses. This information is relevant because the majority of
information regarding small businesses is soft and non-verifiable. Thus, more subjectivity is
used by agents in making decisions.

3. What is the key problem that emerges when decision rights are organized as they are
while serving the kind of customers that they do?

Information asymmetry

Moral hazard

The key problem is that agents are using the absence of hard, verifiable data for their benefit.
Agents have incentives to approve a greater number of loans, as their bonus (up to 12%)
depends on the amount of loans granted, and the number of new customers served. In
addition, because the information is non-verifiable, thus, there are no required audited
financial reports, there would be no evidence that the agent made a wrong decision while
approving the loan. Moreover, each agent is subject to an annual 6% salary increase, where
both objective output measure and subjective competence measure play equal roles. The
actions that agents are doing is called optimistic bias.
 4. What are the two components of the riskiness of a loan? In addition, how do loan
rates move (increase or decrease) when the credit risk and total outstanding debt
increase? Does this make sense to you?

The two components are the internal risk rating of the likelihood of default and the extent to
which debt is collateralized. When the internal risk rating of the likelihood of default is high
and the extent to which debt is collateralized is low, the credit risk is higher.

5. What is the main takeaway from Table 5? Is this consistent with the key problem that
you discussed at point 3.

Yes, as results show when ratification is transferred to the higher-level agents, lower-level
agents positively evaluate the risk-return characteristics of the loan application. This leads to
a higher probability of downgrading the credit quality after approval.

6. What is the main takeaway from Table 6? Is this consistent with the key problem that
you discussed at point 3.

The results show that the discount provided on a loan was mostly given to businesses, which
information did not contain formally audited financial statements. This is in line with the key
problem.

Wallace (1997)

1. What do we mean with the statement that ‘the use of traditional earnings in incentive
compensation contracts may lead to overinvestment?’

That the cost of debt financing is charged against earnings in the form of interest expense on
existing debt. This means that these costs are not charged against equity. Thus, any project
that is expected to earn greater than the embedded cost of debt increases the absolute level of
earnings, even though it reduces shareholder wealth. This can lead to overinvestment because
the projects are being selected, even though they do not match the required rate of return
from equity holders.

2. Why would residual income (as performance measure in their incentive compensation
contract) reduce these overinvestment problems?
Because residual income is earnings before interest minus capital charge on total capital.
Thus, it charges costs against both equity and debt capital. In addition, managers are
penalized, if they accumulate capital that is not able to earn at least the firm’s opportunity
cost of capital.

3. What is the main takeaway from Table 3? Explain these findings.

H1: Ceteris paribus, asset dispositions will increase, and new investment will decrease for firms following the
adoption of a residual income-based compensation plan, relative to firms where the manager is evaluated and
compensated based on traditional earnings measures.

The main takeaway is that companies that adopted residual income-based compensation plan,
have a decrease in new investments of 5% of total assets and an increase in dispositions of
1% of total assets. This shows that the projects are being tested to a higher rate of return and
old assets that decreased in value are being sold.

4. What is the main takeaway from Table 4? Explain these findings?

H2: Ceteris paribus, overall share repurchases, and dividend payouts will increase for firms following the
adoption of a residual income-based compensation plan, relative to firms where the manager is evaluated and
compensated based on traditional earnings measures.

The main takeaway is that both repurchases per share and dividends per share increase after
the adoption of a residual income-based compensation plan compared to the pre-adoption
period. Repurchases and dividend payouts decrease the capital, which leads to higher residual
income.

5. What is the main takeaway from Table 5 if you solely focus on asset turnover as the
dependent variable? Explain these findings?

H3: Ceteris paribus, total asset turnover will increase for firms following the adoption of a residual income-
based compensation plan, relative to firms where the manager is evaluated and compensated based on traditional
earnings measures.

The main takeaway is that total asset turnover increases by 0.09 and accounts receivable
turnover increased by 0.55 after the adoption of residual income-based compensation plan.
This shows that the company is using existing assets more efficiently to generate profit.
 6. We also discussed underinvestment problems. What do we mean with
underinvestment problems? Can residual income also be used to address
underinvestment problems?

An underinvestment problem is when a leveraged company is not investing in projects to

stimulate the company’s growth. Residual income-based compensation plan is not a solution
in the current situation.

Vyaderm business case

1. Describe the old incentive and control system? What are the main problems that
emerge from this according to Maurice Vedrine?

According to the case, the previous CEO Tom Finn was running a company with a singular
focus on EPS. Thus, the focus of the business was short-term oriented. And performance
measure was subjective.

The employees received bonuses annually. The bonus consisted of 2 parts, one objective
operating results and another subjective evaluation of managers’ contribution.

Thus, managers focused more on the subjective part, rather than improved the profitability of
the company.

2. What do we mean with Economic Value Added (EVA)? What are the main
modifications that are made relative to traditional (GAAP) earnings measures? What
does Maurice Vedrine expects to achieve with the introduction of the EVA measure?

EVA is a modified version of Residual Income. Residual Income measures the extent to
which a company’s after-tax operating profit covers the shareholder’s cost of capital. EVA
was one of the measures that took into account the cost of capital. The formula is as follows:

EVA = Net Operating Profit after tax – (Capital * Cost of Capital)

EVA helps hold managers accountable for the capital provided by investors and aligns the
interests of divisional managers, the company, and the shareholders. EVA is a tool that
combines the income statement and the balance sheet into one number, by subtracting from
earnings a charge for the utilization of assets employed in generating those earnings. Vedrine
expected that EVA would motivate people to think long-term.

The adjustments were done to the following 4 accounts:

1.R&D expenditures were capitalized and amortized on a straight-line basis over 5 years
period.

2.Consumer advertising expenses were capitalized and amortized on a straight-line basis over
3 years period.

3.Goodwill from acquisitions was written down if exceeded the FV of the underlying assets.

4.Restructuring expenses were removed from profit or loss statement and added back to net
operating assets.

3. With regard to the implementation, Vedrine initially decides to adopt one corporate
EVA center and after criticism shifted toward the adoption of 15 EVA centers. This
plan is also aborted and it is ultimately decided to adopt 4 EVA centers. What was the
main problem of one EVA center and the main problem of 15 EVA centers?

1 Corporate EVA Center: the main problem was in the lack of sensitivity (there was to what
extent can employee influence measure)

15 Corporate EVA Center: the main problem was in underestimating the amount of work that
had to be done for a proper evaluation. Some businesses did not have a full balance sheet, and
there were also transfer pricing issues.

4. Does it make sense for a pharmaceutical company to consider the adoption of EVA?

Yes, because a pharmaceutical company spends a lot on R&D, which under GAAP would be
expensed immediately. However, with the adoption of EVA, those costs, as well as
advertisement costs would be gradually expensed over 3 or 5 years. This would allow for a
better understanding of company’s profitability in the long term.

5. What is the EVA for Dermatology for 2017? EXAM!!!!!c

 Net Income 43500 Net Operating 135000
Before Tax Assets
R&D Expense 39000 Capitalized R&D 14610*1/5 +
Assets
17094*2/5+20000*3/5+

39000*4/5=52960
Amortization (12437+14610+ Capitalized 45*1/3+50*2/3= 48
R&D Expense Advertising Assets
17094+20000+

39000)/5=(20638,2)
Consumer 50 Goodwill 10000
Advertising Impairment
Expense
Amortization (41+45+50)/ Modified Capital 198008
Consumer 3=(45,3)
Advertising
Expense
Goodwill 10000
Amortization
Tax (18725)
Modified Net 53142
Operating Profit
Before tax

EVA=53142- (11%* 198008)= 31361

6. Competitor PJL had to close down due to no longer being FDA compliant. What
would you recommend Maurice Vedrine with respect to the unusually high EVA
performance for Dermatology in 2017?

Smooth it out in years

Because unusually high EVA was due to external event, rather than a great performance of
the company, I would recommend not to increase the reward.