Chapter 12 Agency Problems, Compensation, and Performance Measurement 325
bre44380_ch12_302-326.indd 325 10/09/15 09:56 PM
Year
0 1 2 3
Cash flows ($ millions) – 12 +5.20 +4.80 +4.40No cash flows are forecast after year 2, and the equipment will have no salvage value. The
cost of capital is 10%.
a. What is the project’s NPV?
b. Calculate the expected EVA and the return on investment in each of years 1 and 2.
c. Why does EVA decline between years 1 and 2, whereas the return on investment is
unchanged?
d. Calculate the present value of the economic value added. How does this figure compare
with the project NPV?
e. What would be the return on investment and EVA if OBP chooses instead to depreciate
the investment straight line? Do you think that this would provide a better standard for
measuring subsequent performance?
CHALLENGE
- Accounting measures of performance Consider an asset with the following cash flows:
The firm uses straight-line depreciation. Thus, for this project, it writes off $4 million per
year in years 1, 2, and 3. The discount rate is 10%.
a. Show that economic depreciation equals book depreciation.
b. Show that the book rate of return is the same in each year.
c. Show that the project’s book profitability is its true profitability.
You’ve just illustrated another interesting theorem. If the book rate of return is the same in
each year of a project’s life, the book rate of return equals the IRR.
- Accounting measures of performance In our Nodhead example, true depreciation was
decelerated. That is not always the case. For instance, Table 12.6 shows how on average the
Start of Year Market Value Cash Flow
1 19.69
2 17.99 $3.67
3 16.79 3.00
4 15.78 2.69
5 14.89 2.47
6 14.09 2.29
7 13.36 2.14
8 12.68 2.02
9 12.05 1.90
10 11.46 1.80
11 10.91 1.70
12 10.39 1.61
13 9.91 1.52
14 9.44 1.46
15 9.01 1.37
16 8.59 1.32❱ TABLE 12.6 Estimated
market values of a Boeing
737 in January 1987 as
a function of age, plus
the cash flows needed to
provide a 10% true rate of
return (figures in $ millions).