CHAPTE R 35

SHAREHOLDER VALUE AND CORPORATE GOVERNANCE

LEARNING OBJECTIVES

Emphasize

the need for a linkage between the financial goals and strategy Focus on the shareholder value creation Develop a framework for the shareholder value analysis Discuss the concept and measurement of economic value added (EVA) and market value added (MVA) Explain the significance of balanced scorecard as a comprehensive performance system Highlight the features of good corporate governance

FINANCIAL GOALS AND STRATEGY

Financial

goals are the quantitative expressions of a companys mission and strategy, and are set by its long-term planning system, as a trade-off among the conflicting and competing interests.

Characteristics of a companys financial goals system (Donaldson):

Companies

are not always governed by the maximum profit

criterion. Financial priorities change according to the changes in the economic and competitive environment. Competition sets the constraints within which a company can attain its goals. Managing a companys financial goals system is a continuous process of balancing different priorities, in a manner that the demand for and supply of funds is reconciled.

Cont
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change in any goal cannot be effected without considering the effect on other goals. Financial goals are changeable and unstable, and therefore, managers find it difficult to understand and accept the financial goals system.

Corporate managers in India consider the following four financial goals as the most important:
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Ensuring

fund availability Maximizing growth Maximizing operating profit before interest and taxes Maximizing return on investment

SHAREHOLDER VALUE CREATION

The

value of a firm is the market value of its assets which is reflected in the capital markets through the market values of equity and debt.
Shareholder value = Market value of the firm Market value of debt

Methods of Shareholder Value

first method, called the Free Cash Flow Method, uses the weighted average cost of debt and equity (WACC) to discount free cash flows.
FCF PBIT (1 T ) DEP ONCI NWC CAPEX

The

When

the value of a firm or a business over a planning horizon is calculated, then an estimate of the terminal cash flows or value (TV) will also be made:
Economic value = PV of net operating cash flows (NOCF) + PV of terminal value

FCF

do not include financing (leverage) effect, and therefore, they are unlevered or ungeared cash flows. The weighted average cost of capital (WACC) includes after-tax cost of debt. Hence the financing effect is incorporated in WACC rather than cash flows.

Methods of Shareholder Value

Second method calculates the economic value of a firm or business in to two parts: Value of a levered firm = Value of unlevered firm + Value of interest tax shield Steps Estimate the firms unlevered cash flows and terminal value. Determine the unlevered cost of capital (ku). Discount the unlevered cash flows and the terminal value by the unlevered cost of capital. Calculate the present value of the interest tax shield discounting at the cost of debt. Add these two values to obtain the levered firms total value. Subtract the value of debt from the total value to obtain the value of the firms shares. Divide the value of shares by the number of shares to obtain the economic value per share.

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Methods of Shareholder Value

The

third method for determining the shareholder economic value is to calculate the value of equity by discounting cash flows available to shareholders by the cost of equity.
Equity cash flows FCF + INT(1 T )

Market Value Added

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In

terms of market and book values of shareholder investment, shareholder value creation (SVC) may be defined as the excess of market value over book value. SVC is also referred to as the market value added (MVA): Market value added = Market value invested capital (capital employed)

Market-to-Book Value (M/B)

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An

alternative measure of shareholder value creation:

Market value of equity = Market value of the firm Market value of debt
The

market-to-book value (M/B) analysis implies the following:

Value creation If M/B > 1, the firm is creating value of shareholders. Value maintenance If M/B = 1, the firm is not creating value of shareholders. Value destruction If M/B < 1, the firm is destroying value of shareholders.

Market-to-Book Value (M/B)

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We

obtain M/B equation as follows:

M ROE g = B ke g

The

following are the determinants of the M/B ratio:

Economic profitability or spread Growth Investment period

Economic Value Added (EVA)

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Economic

value added is a measure which goes beyond the rate of return and considers the cost of capital also. Economic value added, economic profit or residual income is defined as net earnings (PAT) in excess of the charges (cost) for shareholders invested capital (equity):
Economic value added PAT Charges for equity PAT Cost of equity Equity capital
The

firm is said to have earned economic return (ER) if its return on equity (ROE) exceeds the cost of equity (COE):
Economic return = ROE COE

Advantages
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EVA can be calculated for divisions and even projects. EVA is a measure that gauges performance over a period of time rather than at a point of time. EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions. MVA, on the other hand, is a stock variable. EVA is not bound by the Generally Accepted Accounting Principles (GAAP). As we discuss below, appropriate adjustment are made to calculate EVA. This removes arbitrariness and scope for manipulations that is quite common in the accounting-based measures. EVA is a measure of the firms economic profit. Hence, it influences and is related to the firms value.

EVA Adjustments
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Impaired

or non-performing assets Research and Development Deferred Tax Provisions LIFO Valuation of Inventory Goodwill Leases Restructuring charges

Evaluation of M/B and EVA

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Both

M/B and EVA approaches focus on economic profitability rather than on accounting profitability. Both the approaches are an improvement over the traditional accounting measures of performance. But both do suffer from the limitation that they are partially based on accounting numbers.

Value Drivers
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Drivers

of EVA or Value based on the Discounted Cash Flow Approach:

Revenue enhancement Cost reduction Asset utilisation Cost of capital reduction

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MANAGERIAL IMPLICATIONS OF SHAREHOLDER VALUE

The

shareholder value approach is based on the assumption that a principal-agent relationship exists between the shareholders and the management. The foundation of SVC is the notion that the shareholder value depends on future cash flows and their risk. The cost of capital, accounting for the timing and risk of future cash flows, is used to determine the present value of cash flows. SVC takes a long-term perspective and focuses on valuation.

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SVC

can be used to evaluate the consequences of the strategies pursued by the company. At the business unit or divisional level, it is used to evaluate the alternative competitive strategies, to identify the key business factors that impact SVC and to set performance targets that are consistent with value creation. At the corporate level, it is used to evaluate the contribution of the strategies followed by business units/ divisions, to form strategic combinations of businesses that will create maximum value, to identify products or businesses for divestiture and to mergers and acquisition activities.

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BALANCED SCORECARD

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Should a balanced scorecard always balance?

To

be an effective management system, the balanced scorecard must be implemented as a performance improvement process; it will not serve its purpose if it is used just as an IT-driven control system. balanced scorecard is a critical component of the strategic planning process which involves creative thinking, communicating, sharing, informing, analyzing, understanding, etc.

The

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Conditions necessary for Implementing Balanced Scorecard System

Top

management commitment and support Determine the critical success factors (CSFs) Translate CSFs into measurable objectives (metrics) Link performance measures to rewards Install a simple tracking system Create and link the balanced scorecards at all levels of the organization Communication Link strategic planning, balanced scorecard, and budgeting process

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Significance of the Balanced Scorecard

Increase

in customer focus Focus on creating intangible and intellectual capital Business excellence and growth Align strategy to operations at all levels of the organization Real-time review

CORPORATE GOVERNANCE
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Corporate

governance implies that the company would manage its affairs with diligence, transparency, responsibility and accountability, and would maximize shareholder wealth.

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Theories of Corporate Governance

The

agency theory The stewardship theory The stakeholder theory The political theory

Corporate Governance
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Companies

are needed to at least have policies and practices in conformity with the requirements stipulated under Clause 49 of the Listing Agreement.

Board of Directors The Board of Directors should be composed of Executive and Non-Executive Directors meeting the requirement of the Code of Corporate Governance.

Corporate Governance
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Audit Committee The appointment of the Audit Committee is mandatory, and its a very powerful instrument of ensuring good governance in the financial matters. Shareholders/Investors Grievance Committee As a part of corporate governance, companies should form a Shareholders/Investors Grievance Committee under the Chairmanship of a non-executive independent director.

Corporate Governance
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Remuneration Committee The company may appoint a Remuneration Committee to decide the remuneration and other perks etc. of the CEO and other senior management officials as the Companies Act and other relevant provisions. Management Analysis Management is required to make full disclosure of all material information to investors.

Corporate Governance
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Communication The quarterly, half-yearly and annual financial results of the Company must be sent to the Stock Exchanges immediately after they have been taken on record by the Board. Auditors Certificate on Corporate Governance The external auditors are required to give a certificate on the compliance of corporate governance requirements.