CORPORATE SOCIAL RESPONSIBILITY

BASIC OBJECTIVE OF THE FIRM (contd..) MERITS OF THE EVA CONCEPT 1. It is not governed by the generally accepted accounting practices (GAAP). Its users are free to make the necessary adjustment for arriving at more meaningful and conceptually valid conclusions. 2. This concept is based on the concept of net present value (NPV) of the long-term capital employed in the business. Hence it gives superior and more realistic result vis--vis accounting rate of return. 3. Earlier companies were generally using separate measures like accounting rate of return (ARR) or operating profit as a percentage of total capital employed (debt + equity). This concept does not take care of the economic cost of capital employed. In contrast, EVA is based on the sound concept of opportunity cost of capital or the discounting principle. 4. It is a superior concept vis--vis conventional accounting measures in determining employees stock option (ESOP) or bonus. It aligns the interests of managers as well as shareholders, as it harmonizes the interest of owners or the managers and resolves the agency problems, thereby minimizing organizational conflict. 5. It reduces the managers incentive to manipulate accounting profits. This is so because creation of more EVA results in greater benefits to both the shareholders and the managers. This can also be used for revision of compensation of the staff members. 6. The concept of EVA is highly dynamic and futuristic and it keeps the managers and staff constantly under pressure to show superior

performance and thereby improves their pay package on continuous basis. 7. The concept of EVA is primarily based on the old concept of quasirent developed by Richard and Alfred Marshall. It is a concept that has not only survived, but is surviving even after more than a century. MARKET VALUE ADDED (MVA) Market Value Added refers to the present value of the firm minus the total capital (equity capital + preference capital + debenture or bond + any long-term loan). It is represented as: MVA = Total value of the firm Total economic capital Total value of the firm increases due to more efficient utilization of the existing capital in highly profitable lines, thus, resulting in higher market value additions in the shareholders wealth due to increase in the market price of the shares.
Firms Decision

Investing

Financing

Distributing

Risk

Firms Decision

Value of the Firm

Factors Affecting Share Values

Hurdle Rate: Hurdle Rate is the minimum rate of return that must be generated by the project in order to keep the capital intact. It is, in fact, the cost of the capital deployed in the business at a given point of time. Sources of fund (i.e., debt and equity have different risk profiles) The cost of equity would generally vary in predictable manner as follows: Cost of equity will be generally higher than debenture or term loan for a firm. The cost of equity of a firm in a normal risk business would be lower than in a higher risk business. That means the higher element of risk, higher will be the cost of equity of the business firm. Thus for an investors expected rate of return: Expected Rate of Return = Opportunity cost of capital of the firm + Risk premium.