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Why capital efficiency measures are rarely used in incentive plans, and how to change that

Author: O'Byrne, Stephen F. ; Young, S. DavidINSEAD Area: Accounting and ControlIn: Journal of Applied Corporate Finance, vol. 21, no. 2, spring 2009 Language: EnglishDescription: p. 87-92.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: Most finance academics, along with many corporate practitioners, believe that discounted cash flow, or DCF, is the most reliable method for calculating the market value of a company’s shares. The use of DCF in turn implies that shareholders are better off when companies invest only in projects that are expected to earn more than the cost of capital — and when they pay out, through dividends or stock buybacks, capital that is expected to earn less than the shareholders' opportunity cost. Despite the wide acceptance of these principles, very few companies use performance measures that focus on corporate efficiency in using capital — measures such as return on capital (ROC) or economic value added (EVA) — as the main basis for their top management incentive programs. In this article, we start by documenting the limited use of capital efficiency measures in top management incentive plans. Second, we analyze three often cited problems with capital efficiency measures that may well account for their limited use. Third and last, we suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance
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Most finance academics, along with many corporate practitioners, believe that discounted cash flow, or DCF, is the most reliable method for calculating the market value of a company’s shares. The use of DCF in turn implies that shareholders are better off when companies invest only in projects that are expected to earn more than the cost of capital — and when they pay out, through dividends or stock buybacks, capital that is expected to earn less than the shareholders' opportunity cost. Despite the wide acceptance of these principles, very few companies use performance measures that focus on corporate efficiency in using capital — measures such as return on capital (ROC) or economic value added (EVA) — as the main basis for their top management incentive programs. In this article, we start by documenting the limited use of capital efficiency measures in top management incentive plans. Second, we analyze three often cited problems with capital efficiency measures that may well account for their limited use. Third and last, we suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance

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