Economic profit and shareholder value relate to strategy because...

• A. Strategy should maximize returns beyond the cost of capital.
• B. They are separate and unrelated to strategy.
• C. Strategy should minimize profits to reduce taxes.
• D. Shareholder value is the only goal; cost of capital is irrelevant.

Answer: (A)

The main idea is that economic profit and shareholder value come from earning returns that exceed the cost of capital. The cost of capital, often captured by the weighted average cost of capital (WACC), is what investors require to fund the firm’s investments. When a strategy directs resources into activities that generate operating profits after taxes that exceed the capital charge on those assets, value is created for shareholders. In other words, if the return on invested capital (ROIC) is greater than the cost of that capital, the firm adds economic profit and raises the present value of future cash flows, boosting shareholder value. Strategic decisions—what markets to enter, what capabilities to build, and how to allocate capital—should be evaluated by whether they lift economic profit, not merely by short-term profits or tax considerations.