eva roe question

CFA Level II
#1

Which of the following statements most accurately explains the relationship between profitability and wealth creation? For a firm to create wealth for its shareholders it: A) necessarily needs to have positive ROE; it may or may not have positive EVA. B) necessarily needs to have positive economic value added (EVA); it may or may not have positive return on equity (ROE). C) necessarily needs to have positive EVA and positive ROE. D) does not necessarily need to have positive EVA or positive ROE.

#2

C

#3

C And ROE >R

#4

C? But shouldn’t it be -> Positive EVA, positive ROE, and ROE > WACC else it would destroy stockholders value? … off what good is a positive ROE which is less than it’s WACC :frowning:

#5

that is what i think as well however the answers given do not mention the required rate of return so which answer would you pick in this case? I will go with C

#6

i’m going with B…

#7

MUMUKADA! Your answer: C was incorrect. The correct answer was B) necessarily needs to have positive economic value added (EVA); it may or may not have positive return on equity (ROE). For a firm to create wealth for its shareholders it necessarily needs to have positive EVA; it may or may not have positive ROE.

#8

so where does ROE >R go in the equation. I was under the impression that this should apply as well!

#9

ok …so here’s how I thought about it… the whole idea of calculating EVA is to compare it to ROE. Economic VALUE ADDED (as the name implies) is measuring the economic profitability. The fact is , they are telling analysts to use this BECAUSE it is a better representation of shareholder wealth creation than ROE. Main reason?? Well economic profitability (EVA) measures the profits while including both the cost of equity AND debt Accounting Profitability (ROE) measures the profits but has ONLY incorporated the debt cost (via interest expense) - and so IS NOT a true measure of value created for shareholders… basically you can have positive EVA and negative ROE. Positive EVA means you have enough to money to cover your operating expenses and capital costs (both equity and debt) But your ROE could become negative (if you include big losses below your EBIT line) but that is not such an accurate measure since you never accounted for the cost of your equity stake…

#10

Thanks mumukada