University of Rhode Island
Department of Accounting
College of Business Administration

Directed Study
A Shareholder Value
and Agency Theory Based
Compensation System

by

Arne Wolter

Table of Contents

Table of contents ... III
Table of figures ... V
List of tables ... V
Frequently used symbols ... VI

1 Introduction ... 1

2 Rationale For The Shareholder Value Approach ... 3
2.1 Value-based Management ... 4
2.1.1 Shareholder versus Management Interests ... 5
2.1.2 The Relation to other Stakeholders ... 6
2.2 Shortcomings of Accounting Numbers ... 7
2.2.1 Unreliable Performance Measurement - Earnings ... 8
2.2.1.1 LIFO versus FIFO ... 8
2.2.1.2 The Amortization of Goodwill ... 9
2.2.1.3 Time Value of Money ... 10
2.2.2 Return on Investment (ROI) and Return on Equity (ROE) ... 12
2.2.3 Long-term View ... 14
2.2.4 Intellectual Capital ... 15

3 Shareholder Value Analysis Methods ... 17
3.1 Rappaport´s Framework For Value Creation ... 17
3.1.1 The Estimation of the Cash Flow ... 18
3.1.2 Cost of Capital ... 19
3.1.2.1 Cost of Equity ... 20
3.1.2.1.1 The Risk-Free Rate ... 21
3.1.2.1.2 The Market-Risk Premium ... 22
3.1.2.1.3 Estimating the Systematic Risk ... 24
3.1.2.2 Cost of Debt ... 25
3.1.3 Residual Value ... 26
3.1.4 Rappaport′s Shareholder Value Network ... 29
3.2 Copeland, Koller and Murrin Approach (McKinsey) ... 31
3.3 ECONOMIC VALUE ADDED (EVA®) ... 34

4 Assessment Of The Shareholder Value Analysis Methods ... 38
4.1 Similatities & Distinctions... 38
4.2 Problematic Issues ... 41
4.2.1 Information Deficits ... 41
4.2.2 Hockey-Stick Effect ... 43
4.2.3 Compound Problem ... 45
4.2.4 Manipulation Problem ... 45

5 Performance Evalutation And Compensation Systems ... 47
5.1 Agency theory overview ... 48
5.2 Principal-Agent conflicts ... 50
5.2.1 Adverse Selection ... 51
5.2.2 Moral Hazard ... 52
5.2.3 The Horizon Problem ... 54
5.2.4 Risk Differential Behavior ... 55
5.3 Compensation Systems ... 57
5.3.1 Recent Research ... 58
5.3.2 Performance Measurement ... 59
5.3.3 Stock Options ... 60
5.3.3.1 Rewarding Outperformance ... 61
5.3.3.2 Including Operating Units and Setting Targets ... 62
5.4 E-Business:: a paradigm for innovative performance driven compensation systems ... 65

6 Prospect And Development ... 67

7 Conclusion ... 68

References ... 70

Table of Figures
Figure 1: EPS Growth Is A Poor Predictor For Shareholder Value ... 11
Figure 2: Security Market Line (SML) ... 25
Figure 3: The Weighted Average Cost Of Capital (WACC) ... 26
Figure 4: The Shareholder Value Network ... 30
Figure 5: Comparison Of Total Value Distribution Based On Different Forecast Periods ... 33
Figure 6: Hockey-Stick Effect ... 44
Figure 7: Agency Problems ... 57
Figure 8: Compensation System In Combination With The Shareholder Value Network ... 59
Figure 9: Holistic Compensation System ... 64

List of Tables
Table 1: Elements Of The Shareholder Value Methods ... 38

1 Introduction

"The fundamental goal of all business is to maximize shareholder value."¹ This statement has become commonplace not only in corporate America, but it is also the imperative statement of business around the world. A failure to seek to maximize shareholder value results in pressure from the board of directors and activist shareholders. The takeover movement of the latter half of the 1980s provided another powerful incentive for managers to focus on creating value. This is grounded on the fact that the only compelling takeover defense is to deliver superior shareholder value.

Given the globalization of capital markets and their diminishing boundaries, economic systems will slowly run out of capital, if they are unable to create shareholder wealth and thereby attract investors. If economic systems are unable to provide superior or at least satisfying returns they will fall further and further behind in global competition and will lose employment opportunities. Thus, a value-based system grows in importance as capital becomes more mobile.

Although shareholder value metrics and value-based management are widely known they are far from being universally applied. Years of restructuring and employee layoffs frequently attributed to shareholder value considerations coupled with self-interested management and shortsighted focus on current stock price has promoted frustration and uncertainty.² Thus, it is critical to fully understand the shareholder value approach and its variants. Additionally, it is vital for the shareholder value approach that the objectives of the mangers and the company′s shareholders are aligned and focused on delivering superior shareholder value. The relationship between manager and stockholder can best be examined by the agency theory that studies the contract between agents (e.g. managers) and principals (e.g. stockholders).³ An overview of a holistic shareholder value and agency based compensation system is the topic of this paper.

Based on the above discussion this paper first introduces the shortcomings of traditional accounting numbers and reveals the need for a more reliable measure: shareholder value. The third chapter then explains the shareholder value approach and three key methods are introduced: Rappaport′s shareholder value added (SVA), Copeland, Koller and Murrin′s total shareholder value, and Stern and Stewart′s economic value added (EVA). The following section reveals the major differences, respectively similarities of these methods in the areas of determination of the relevant cash flow and the cost of capital as well as the calculation of the residual value. Moreover, it indicates problems of which the manger should be aware of when applying shareholder value measurements. Chapter 5 introduces the agency theory with its central problems. These problems, which are responsible for the occurrence of agency costs, will be explained in detail. Based on those findings a compensation system grounded on the two established theories and a holistic compensation approach is introduced. Finally, E-business compensation packages, which seems to be the paradigm for innovative compensation systems, are touched upon briefly. The last two sections provide ideas for future research objectives and also summarize and conclude the paper.

2 Rationale for the Shareholder Value Approach

The idea that management′s focus and responsibility is to increase value has gained widespread acceptance.⁴ The discussion of shareholder value and its creation first gained prominence with the publication in 1986 of Creating Shareholder Value by the U.S. academic Alfred Rappaport.⁵ Although shareholder value orientation is commonplace in most businesses it is still a high-decibel debate whether the manager′s sole focus should be to increase the firm′s value. A common criticism touching shareholder value is often the misunderstanding that a value-based strategy disregards the other stakeholder of the company.⁶ Another often articulated demur is that a strict shareholder value orientation might lead toward a short-term focus of business strategies.⁷ Proponents of this "balanced Stakeholders" approach point out the very high standards of living and rapid economic growth in Europe and Japan to support their view.⁸

However, the evidence against these arguments - and in favor of value-based shareholder wealth maximization - is mounting.⁹ Thus this chapter describes cornerstones of a  valuebased management (VBM) and will provide evidence that it will lead to greater increases in shareholder wealth. In other words, even in an increasingly competitive world, shareholder value maximization will grant benefits for all stakeholders due to the fact that there is no evidence of any conflict between shareholders and other interest groups.¹⁰ These other groups also include the management of the company, which may have in some situations different objectives than the shareholders of the company. To prevent the company from such kinds of potential interest conflicts it is essential to put performance tied compensation systems in place, which will not only lead to better performance of the employees, but also will lower the need for performance and decision control mechanism installed by the stockholders of the company.

[...]

1 Copeland, T.E. (1994), p 97.

2 Wiseman, R. M./Gomez-Mejia, L. R. (1998), p. 133.

3 Rappaport, A. (1998), p. 3.

4 Rappaport, A. (1998), p. 1.

5 Black, A./Wright, P./Bachman, J. E./Davies, J. (1998), p. 22 and Kay, H. (1991), p 71.

6 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 22.

7 Copeland, T.E. (1994), p 97.

8 Rappaport, A. (1998), p. 5. and Copeland, T.E. (1994), p 97.

9 Copeland, T.E. (1994), p 97.

10 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 4.