Why Capital Efficiency Measures Are Rarely Used in Incentive Plans, and How to Change That

Despite the wide acceptance of DCF valuation and its corollary that value is created only by earning more than the cost of capital, 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, the authors begin by documenting the surprisingly limited use of such measures in management incentive plans. Next they analyze three often cited problems-difficulty in retaining managers, discouragement of growth investment, and complexity-that could account for the limited use of such measures. Third and last, they 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. Copyright Copyright (c) 2009 Morgan Stanley.