Scribd
Upload
103 views4 pages

Ans. Financial Management: Q. What Is Meant by Maximization of Corporate Wealth

Economic value added (EVA) measures a company's economic profit over a period of time by taking net operating profits and subtracting the cost of capital. Market value added (MVA) measures the total market value of a company compared to the capital contributed by investors, representing accumulated wealth over time. While EVA assesses economic success, MVA acts as a wealth measure of the value a company has built up. EVA incorporates the opportunity cost of capital, while MVA does not.

Uploaded by

Kanishka Chhabria
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
103 views4 pages

Ans. Financial Management: Q. What Is Meant by Maximization of Corporate Wealth

Economic value added (EVA) measures a company's economic profit over a period of time by taking net operating profits and subtracting the cost of capital. Market value added (MVA) measures the total market value of a company compared to the capital contributed by investors, representing accumulated wealth over time. While EVA assesses economic success, MVA acts as a wealth measure of the value a company has built up. EVA incorporates the opportunity cost of capital, while MVA does not.

Uploaded by

Kanishka Chhabria
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

Q.

What is meant by maximization of corporate wealth 


ANS. Wealth maximization is a modern approach to financial management.
Maximization of profit used to be the main aim of a business and financial
management till the concept of wealth maximization came into being. It is a
superior goal compared to  as it takes broader profit maximization arena into
consideration. Wealth or Value of a business is defined as the market price of
the capital invested by shareholders.
It simply means maximization of shareholder’s wealth. It is a combination of
two words viz. wealth and maximization. A wealth of a shareholder maximizes
when the net worth of a company maximizes. To be even more meticulous, a
shareholder holds share in the company/business and his wealth will improve
if the share price in the market increases which in turn is a function of net
worth. This is because wealth maximization is also known as net worth
maximization
Finance managers are the agents of shareholders and their job is to look after
the interest of the shareholders. The objective of any shareholder or investor
would be a good return on their capital and safety of their capital.

Both these objectives are well served by wealth maximization as a decision


criterion for business.

ADVANTAGES OF WEALTH MAXIMIZATION MODEL


Wealth maximization model is a superior model because it obviates all the
drawbacks of profit maximization as a goal of a financial decision.
 Firstly, the wealth maximization is based on cash flows and not on
profits. Unlike the profits, cash flows are exact and definite and therefore
avoid any ambiguity associated with accounting profits. Profit can easily be
manipulative, if there is a change in accounting assumption/policy, there is a
change in profit. There is a change in method of depreciation, there is a change
in profit. It is not the case in case of Cashflows.
 Secondly, profit maximization presents a shorter term view as compared
to wealth maximization. Short-term profit maximization can be achieved by the
managers at the cost of long-term sustainability of the business.
 Thirdly, wealth maximization considers the time value of money. It is
important as we all know that a dollar today and a dollar one-year latter do not
have the same value. In wealth maximization, the future cash flows are
discounted at an appropriate discounted rate to represent their present value.
Suppose there are two projects A and B, project A is more profitable however
it is going to generate profit over a long period of time, while project B is less
profitable however it is able to generate return in a shorter period. In a
situation of an uncertainty, project B may be preferable. So, timing of returns is
ignored by profit maximization, it is considered in wealth maximization.
 Fourthly, the wealth-maximization criterion considers the risk and
uncertainty factor while considering the discounting rate. The discounting rate
reflects both time and risk. Higher the uncertainty, the discounting rate is
higher and vice-versa.

Q. What is the difference between EVA and MVA?


ANS. There are numerous ways that investors and lenders can estimate the
value of a company. This becomes increasingly important for individuals
seeking out value investing opportunities in small and large companies.
Valuations can also be used to determine whether a business is a good credit
risk.

The most common metrics used to determine a company's value include


economic value added and market value added. However, there are distinct
differences between these two valuation strategies, and investors need to be
aware of how to use each.

 Economic value added (EVA) and market value added (MVA) are
common ways an investor can assess a company's value.
 EVA is useful as a way to measure a company's economic success, or lack
thereof, over a specific period of time.
 MVA is useful as a wealth measure, assessing the level of value that a
company has built up over a period of time.
Economic Value Added
Economic Value Added (EVA) is a performance measure developed by Stern
Stewart & Co. (now known as Stern Value Management) that attempts to
measure the true economic profit produced by a company. It is frequently also
referred to as "economic profit," and provides a measurement of a company's
economic success (or failure) over a period of time. Such a metric is useful for
investors who wish to determine how well a company has produced value for
its investors, and it can be compared against the company's peers for a quick
analysis of how well the company is operating in its industry.
Economic profit can be calculated by taking a company's net after-tax
operating profit and subtracting from it the product of the company's invested
capital multiplied by its percentage cost of capital.

For example, if a fictional firm, Cory's Tequila Company (CTC), had 2018 net


after-tax operating profits of $200,000 and invested capital of $2 million at an
average cost of 8.5 percent, then CTC's economic profit would be computed as
$200,000 - ($2 million x 8.5%) = $30,000.

This $30,000 represents an amount equal to 1.5 percent of CTC's invested


capital, providing a standardized measure for the wealth the company
generated over and above its cost of capital during the year.

A company's profitability can be gauged by calculating EVA, as its focus is on a


business project's profitability and thus the efficiency of company
management.

Economic value added (EVA) takes into account the opportunity cost of
alternative investments, while market value added (MVA) does not.

Market Value Added


Market Value Added (MVA), on the other hand, is simply the difference
between the current total market value of a company and the capital
contributed by investors (including both shareholders and bondholders). It is
typically used for companies that are larger and publicly-traded. MVA is not a
performance metric like EVA but instead is a wealth metric, measuring the
level of value a company has accumulated over time.

As a company performs well over time, it will retain earnings. This will improve
the book value of the company's shares, and investors will likely bid up to the
prices of those shares in expectation of future earnings, causing the company's
market value to rise. As this occurs, the difference between the company's
market value and the capital contributed by investors (its MVA) represents the
excess price tag the market assigns to the company as a result of its past
operating successes.

Unlike EVA, MVA is a simple metric of the operational capability of a business


and, as such, does not incorporate the opportunity cost of alternative
investments.

You might also like