Question 4 OR (b)
Economic value added and market value added as control techniques
9 marks
- Time to write
- About 18 minutes
- Notes
- Crux notes
Question
Question 4 OR (b) · 9 marksExplain the Economic Added Value and Market Value Added techniques of controlling, and differentiate between them.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- differentiate betweenSet the differences out in a table, basis by basis, not as two separate essays.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Need for value-based measures 1 mark 2 min
- 2 EVA: meaning, formula, illustration 3 marks 5 min
- 3 MVA: meaning and formula 2 marks 4 min
- 4 Differences and use in control 3 marks 5 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Steps 2 and 3 opens with the meaning: a one-line definition, the quickest mark in each.
Short on time? Trim steps 2–4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Need for value-based measures in control
Traditional accounting measures such as net profit and earnings per share ignore the cost of equity capital: a firm can report a profit and yet earn less than its investors could have earned elsewhere at the same risk. Value-based measures correct this by asking whether the firm has created value for its shareholders after charging for all the capital it uses. Two such measures are EVA and MVA.
EVA is the surplus of operating profit after tax over the cost of all capital employed:
EVA = Net operating profit after tax (NOPAT) − (Weighted average cost of capital × Capital employed)
- NOPAT is operating profit after tax, before interest.
- Capital employed is the total funds (equity and debt) invested in the business.
- Weighted average cost of capital (WACC) is the average return required by lenders and shareholders.
A positive EVA means the business earned more than its capital costs: it created value; a negative EVA means it destroyed value even if it reported a profit.
Illustration. A division with capital employed of ₹100 crore, NOPAT of ₹15 crore and a cost of capital of 12 per cent has EVA = 15 − (0.12 × 100) = ₹3 crore: it has created ₹3 crore of value. If NOPAT were ₹10 crore, EVA would be −₹2 crore despite the profit.
MVA is the difference between the market value of the firm and the capital invested in it by shareholders and lenders:
MVA = Market value of the firm (equity and debt) − Capital employed
For a listed company, the market value of equity is the number of shares × market price. A positive MVA shows that the market values the firm above the funds invested: management has created wealth; a negative MVA shows that it has destroyed wealth. MVA reflects the market's estimate of the present value of all future EVAs.
Differences between EVA and MVA
| Basis | EVA | MVA |
|---|---|---|
| Nature | Internal, accounting-based measure | External, market-based measure |
| Period | Value created in a single period (year) | Cumulative value created since inception |
| Basis | NOPAT less capital charge | Market value less capital invested |
| Applicable to | Any firm, division or unit (listed or not) | Mainly listed companies as a whole |
| Use | Measures and controls current performance of managers and units | Shows total wealth created for investors |
| Influence of market sentiment | Not affected | Affected by share-price movements |
| Outlook | Historical/current | Forward-looking (expectations) |
EVA can be set as a target for each division and linked to managers' bonuses, encouraging them to use capital efficiently, avoid low-return investments and dispose of idle assets. MVA is used by top management and investors to judge whether the company as a whole is creating wealth. Together they align managers' decisions with shareholders' interest.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Need for value-based measures | 1 |
| 2 | EVA: meaning, formula, illustration | 3 |
| 3 | MVA: meaning and formula | 2 |
| 4 | Differences and use in control | 3 |
| Total | 9 |
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