ACCA Strategic Professional · Advanced Financial Management · Strategic business and financial planning for multinational organisations
A multinational pays its senior managers a bonus of 2% of the amount by which economic value added exceeds zero. Which of the following is the strongest reason this design is likely to improve alignment with shareholder wealth compared with a bonus based on net profit?
The strongest reason is that EVA deducts a charge for capital employed at the cost of capital. Managers therefore gain nothing from projects earning less than the required return, whereas a net profit bonus ignores the cost of equity and may reward value-destroying investment.
- AEconomic value added ignores the cost of equity finance, so it is easier to calculate
- BEconomic value added deducts a charge for the capital employed, so managers are discouraged from investing in projects that earn less than the cost of capitalCorrect
- CEconomic value added is always unaffected by accounting policy choices
- DEconomic value added guarantees that dividends will increase every year
Explanation
EVA charges for the capital used at the cost of capital, so projects earning below that rate reduce the bonus measure, whereas net profit ignores the cost of equity. Option 0 is the reverse of the truth. EVA is still affected by accounting choices unless adjusted, and it does not guarantee dividends.
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