Jensen on Capital Budgeting Chris Lamoureux Jensen on
Jensen on Capital Budgeting Chris Lamoureux Jensen on Incentives Copyright 1996 -98 © Lamfin, Inc. 12/14/2021 1
Method vs. Process Jensen’s focus is on process. Historically most - if not all - of the focus in corporate finance was on method. But even a tiny bit of consulting with CFOs makes it clear that bad process can destroy the best method, and that with a good process, method is: 1. Not all that important; and 2. Usually optimized (I. e, it is derivative to process) Jensen on Incentives 12/14/2021 2
Why Pay People to Lie? In a January 8, 2001 editorial, Michael Jensen argues that, “we must [eliminate] the use of budget targets in compensation formulas. Only then can we be sure that we are paying people to perform, not to lie. ” What is this about? Jensen on Incentives 12/14/2021 3
Budgets Induce Lying Jensen argues that when confronted with a standard budget / reward system, managers have incentives to play two types of games that he argues destroy firm value: – The Realization of Targets – The Setting of Targets. Jensen on Incentives 12/14/2021 4
Gaming the Realization of Targets • Timing – If a budget is already met, I will shift the realization of revenues to next year, and possibly front-end costs. Conversely, if it appears that I may come up short, I may encourage shifting the realization of revenues. This could be accomplished by marketing tricks (Price rise scheduled for January 2, next year), or fill the channel – verging on fraud. Jensen on Incentives 12/14/2021 5
Gaming the Realization of Targets 2 • Accounting Tricks – – Take gains on the defined benefits pension plan as operating revenues. – Sell assets and realize gains – lease assets back. (Internally, the timing issue is probably the most relevant. ) Jensen on Incentives 12/14/2021 6
Gaming the Setting of Targets The key to understanding this is the notion that the manager has information that his superiors do not. A well-functioning budget process would entail a flow of valuable information up the corporate chain of command. When compensation is tied to the budget, this information flow / co-ordination function is corrupted. Jensen on Incentives 12/14/2021 7
Eliminate Budgets as Targets Jensen argues that telling managers to stop lying will not solve very much. He concludes: [W]e must begin by eliminating the use of budget targets in compensation formulas. Only then can we be sure that we are paying people to perform, not to lie. Jensen on Incentives 12/14/2021 8
A solution ? Jensen provokes thought, but does not propose a solution. Budgets are used in compensation schemes to create incentives for managers to work harder. An alternative to the standard methods would be to have a scenario budget. Managers identify important risks and opportunities which they may confront, and elaborate how results might be impacted by different scenarios. Jensen on Incentives 12/14/2021 9
Specific Knowledge & Divisional Performance The underlying issue in Jensen’s 1999 article in Journal of Applied Corporate Finance is that performance measurement and incentives should be tailored to reflect the extent to which information is decentralized within a company. Thus, there is a suggestion that introducing disparate activities into an organization is costly. Jensen on Incentives 12/14/2021 10
Knowledge & Performance 2. This ties in to the question of spin-offs and organizational focus. If it appears that it is very costly to put into place an effective organizational design, then perhaps the problem lies with the corporate structure. (This is discussed in relationship to the strategic aspects of break-ups. ) Jensen on Incentives 12/14/2021 11
Alternative Systems 1. Cost Centers 2. Revenue Centers 3. Profit Centers 4. Investment Centers & EVA 5. Expense Centers Jensen on Incentives 12/14/2021 12
Cost Centers Here, the incentives are for a divisional manager to minimize costs. This system may be gamed by: 1. Sub-optimal quantity manipulation (May lead to stock outs / excess inventory. ) 2. Sub-optimal quality manipulation (May destroy customer base / loyalty. ) Jensen on Incentives 12/14/2021 13
Cost Centers 2 CFOs are often critical of what they call an “engineering mentality. ” They sense that “engineers” want the latest technology and to show off their skills, when this may not be consistent with value maximization. Jensen on Incentives 12/14/2021 14
Revenue Centers Here, incentives are to maximize revenues. This is often thought to be a corporate objective in a marketing-focused company; (although sometimes market share is targeted). This system may clearly gamed by: 1. “Mortgaging the future. ” 2. Cannibalizing other product lines / divisions. (Imagine that Buick tried to maximize revenues, for example. ) Jensen on Incentives 12/14/2021 15
Profit Centers When the knowledge required to make decisions about the product mix, quantity, and quality is specific to the division, and therefore costly or impossible for managers at higher levels in the hierarchy to obtain, the profit center can be an effective performance measurement system. In these cases it is desirable to use profits as a performance measure while giving profit center managers rights over factors such as the product mix, quantity and quality. (p. 12) Jensen on Incentives 12/14/2021 16
Profit Centers 2. Problems with profit centers include accounting for inter-division complementarities. Another problem is substituting capital for operations. (No incentive to preserve capital. ) Jensen on Incentives 12/14/2021 17
Investment Centers - EVA Here we evaluate profit after subtracting a capital charge. Since this is not a ratio, there is not a scaling problem. This solves the substitution of capital problem that exists in a profit center. It is still static and no panacea. Jensen on Incentives 12/14/2021 18
Expense Centers A service function that does not charge its “internal customers” may under-produce its services. Presumably management higher in the organization knows exactly how much of this service is needed and simply creates incentives for the local manager to provide that level of service at minimum cost. Jensen on Incentives 12/14/2021 19
Big Picture: Dynamic Optimization A problem with all of the systems discussed above is the focus on the short-term, or static optimization. There is no easy way to trade off the competing needs to induce discipline, discourage shirking, and assess talent on the one hand from inducing creativity and a long-term perspective, on the other hand. Jensen on Incentives 12/14/2021 20
Moog as an Extreme I spoke with a group of CFOs about these issues in Spring, 2001. It was clear that corporate solutions vary widely. At one extreme is Moog. This seems to be organized almost like a university. It is assumed that all employees are working for the team. Jensen on Incentives 12/14/2021 21
Real Options shifts Focus A dynamic focus means that when you make a decision, you do not act as if you are committing the company to a lockedin stream of future cash flows. Rather, you are positioning the company to make future decisions. A key here is identifying the optimal reaction to future states of nature. Jensen on Incentives 12/14/2021 22
Lilly and PCS – An Example In November, 1994, Eli Lilly acquired PCS from Mc. Kesson for $4. 1 billion in cash. In January, 1999 Lilly sold PCS to Rite Aid for $1. 6 Billion in cash. PCS is a provider of pharmacy benefit management services. Lilly did not see this as failure. Jensen on Incentives 12/14/2021 23
Real Options Case: Enron In June 1999, Enron opened 3 natural gas-fired power plants in Mississippi and Tennessee (near pipelines). These were cheap, inefficient plants with operating costs 60% higher than state-of-the-art plants. Most of the time, they would be idle. Why? – Volatility in electricity prices means there will be times (possibly rare), when firing up these plants will be very profitable. Jensen on Incentives 12/14/2021 24
Enron Cont’d. Note how the optimizing solution of Enron is not induced by any of the 5 systems discussed by Jensen on Incentives 12/14/2021 25
“Breaking Up is Good to Do” Having reviewed the problems with designing optimal processes for multidivision firms, it is not surprising that transactions which move in the direction of separating a division from the rest of the company may create value. Jensen on Incentives 12/14/2021 26
Sources of Value Creation 1. Increase in Analysts’ Coverage 2. Attract new investors 3. Improved operating performance – better incentives / focus. 4. Improved Governance and strategic flexibility. Jensen on Incentives 12/14/2021 27
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