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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank's board wants to link executive bonuses to shareholder value creation at the business unit level. Which design is most consistent with using EVA?

Link bonuses to positive EVA computed after charging each unit for allocated economic capital at the cost of equity. This rewards only returns above shareholders' required return, discouraging growth that consumes capital without earning its cost, unlike income, ROA or revenue measures.

  1. APay bonuses on a share of positive EVA after charging each unit for its allocated economic capital at the cost of equityCorrect
  2. BPay bonuses on net income growth, since it is unaffected by capital allocation
  3. CPay bonuses on return on assets, since it ignores leverage differences
  4. DPay bonuses on revenue growth, since it is the most controllable measure

Explanation

EVA deducts a capital charge so managers are rewarded only for returns above the shareholders' required return on the risk capital used. Net income, ROA and revenue ignore the cost of risk capital and can reward value-destroying growth.

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