Using Eva To Align Management Incentives With Shareholders’ Interests

594 words - 3 pages

Using EVA to Align Management Incentives with Shareholders’ Interests
Incentive Compensation: The Need and the Challenge
The objective of most incentive compensation programs is to address the ‘agency’ problems that
besiege public companies. Specifically, public firms that hire professional management experience a
natural separation between those that own the firm (the “principals”, i.e., shareholders) and those that
manage the firm (the “agent”). Once can conclude that, for the vast majority of public firms, the owners’
ultimate goal is to maximize their own wealth invested in that firm. In most cases, the board that
shareholders have elected to represent the owners’ interests hires professional managers to accomplish this
goal for them.
However, as Jensen and Meckling observed in a paper they co-authored in the mid-1970’s,
without the proper incentives, most managers will not gravitate towards decisions that maximize ...view middle of the document...

While this is certainly a powerful argument, it is flawed for several reasons. First, due to market
imperfections and volatility, it is often difficult for managers to understand the linkages between their
actions and changes in the firm’s share price. Recent history has reinforced this limitation, as managers
have manipulated short term earnings to meet “Wall Street expectations” despite negative ramifications for
long-term firm value (e.g., early recognition of software sales, “channel stuffing” in the CPG and
pharmaceutical industries). Second, a company’s stock performance is reflective of the performance of
company as a whole and is therefore only an accurate reflection of management skill at the highest levels in
an organization. If equity is used as the primary form of incentive compensation at lower levels of the
organization, for example business unit presidents, a company will be exposed to a “free rider” problem.
Specifically, a business unit manager that has delivered superior performance will not necessarily be
rewarded through an increase in the company’s share price if other business unit managers have fallen short
of expectations and vice versa. G. Bennett Stewart further explains this argument by saying that “stock and
stock options are like issuing only one report card for a whole class of students.”2 A final argument against
the usefulness of stock based compensation is put forth by McTaggart, Kontes and Mankins in their book,
The Value Imperative. They argue that, “the uncertainty a manager faces about future bonuses should be
limited to whether the targets will be achieved; it should definitely not include any uncertainty about the
monetary value the bonus will have. This means that we favor cash or cash equivalents over stock
options.3”
If equity is not the solution, what can owners do to better align managers incentives with the
objective of maximizing firm value? Its proponents suggest that Economic Value Added (“EVA”) is the
answer. I will explore in this paper the rationale for using EVA to align management incentives with a
firm’s wealth creation over time. In the process, I will present two leading perspectives on how to
implement an EVA-based incentive compensation schem

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