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SHAREHOLDER VALUE AND CORPORATE GOVERNANCE
a linkage between the financial goals
Emphasize the need for
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
goals are the quantitative expressions of a company’s mission and strategy, and are set by its long-term planning system, as a trade-off among the conflicting and competing interests.
4 Characteristics of a company’s 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. . in a manner that the demand for and supply of funds is reconciled. Managing a company’s financial goals system is a continuous process of balancing different priorities. Competition sets the constraints within which a company can attain its goals.
.Cont… 5 A change in any goal cannot be effected without considering the effect on other goals. Financial goals are changeable and unstable. managers find it difficult to understand and accept the financial goals system. and therefore.
Corporate managers in India consider the following four financial goals as the most important: 6 Ensuring fund availability Maximizing growth Maximizing operating profit before interest and taxes Maximizing return on investment .
Shareholder value = Market value of the firm – Market value of debt .7 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.
The weighted average cost of capital (WACC) includes after-tax cost of debt. . FCF = PBIT (1 − T ) + DEP ± ONCI ± ∆ NWC − ∆ CAPEX When the value of a firm or a business over a planning horizon is calculated. called the Free Cash Flow Method.8 Methods of Shareholder Value The first method. Hence the financing effect is incorporated in WACC rather than cash flows. uses the weighted average cost of debt and equity (WACC) to discount free cash flows. they are unlevered or ungeared cash flows. and therefore. 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.
Determine the unlevered cost of capital (ku). Divide the value of shares by the number of shares to obtain the economic value per share. Calculate the present value of the interest tax shield discounting at the cost of debt. Subtract the value of debt from the total value to obtain the value of the firm’s shares.9 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 firm’s unlevered cash flows and terminal value. Add these two values to obtain the levered firm’s total value. . Discount the unlevered cash flows and the terminal value by the unlevered cost of capital.
10 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 11 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) .
the firm is creating value of shareholders.12 Market-to-Book Value (M/B) 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 not creating value of shareholders. the firm is destroying value of shareholders. Value destruction –If M/B < 1. Value maintenance – If M/B = 1.
13 Market-to-Book Value (M/B) We obtain M/B equation as follows: M ROE − g = B ke − g The following are the determinants of the M/B ratio: Economic Growth Investment profitability or spread period .
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 .14 Economic Value Added (EVA) Economic value added is a measure which goes beyond the rate of return and considers the cost of capital also.
. EVA is a measure of the firm’s economic profit. MVA. EVA is not bound by the Generally Accepted Accounting Principles (GAAP). it influences and is related to the firm’s value. As we discuss below. Hence.Advantages 15 EVA can be calculated for divisions and even projects. EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions. appropriate adjustment are made to calculate EVA. This removes arbitrariness and scope for manipulations that is quite common in the accounting-based measures. is a stock variable. EVA is a measure that gauges performance over a period of time rather than at a point of time. on the other hand.
EVA Adjustments 16 Impaired or non-performing assets Research and Development Deferred Tax Provisions LIFO Valuation of Inventory Goodwill Leases Restructuring charges .
Both the approaches are an improvement over the traditional accounting measures of performance.17 Evaluation of M/B and EVA Both M/B and EVA approaches focus on economic profitability rather than on accounting profitability. . But both do suffer from the limitation that they are partially based on accounting numbers.
Value Drivers 18 Drivers of EVA or Value based on the Discounted Cash Flow Approach: Revenue enhancement Cost reduction Asset utilisation Cost of capital reduction .
19 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. SVC takes a long-term perspective and focuses on valuation. accounting for the timing and risk of future cash flows. is used to determine the present value of cash flows. The foundation of SVC is the notion that the shareholder value depends on future cash flows and their risk. The cost of capital. .
Cont… 20 SVC can be used to evaluate the consequences of the strategies pursued by the company. . to identify the key business factors that impact SVC and to set performance targets that are consistent with value creation. 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. At the business unit or divisional level. it is used to evaluate the alternative competitive strategies. At the corporate level.
21 BALANCED SCORECARD .
it will not serve its purpose if it is used just as an IT-driven control system. the balanced scorecard must be implemented as a performance improvement process. understanding. communicating. .22 Should a balanced scorecard always balance? To be an effective management system. sharing. The balanced scorecard is a critical component of the strategic planning process which involves creative thinking. etc. analyzing. informing.
23 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. and budgeting process . balanced scorecard.
24 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 .
responsibility and accountability.25 CORPORATE GOVERNANCE Corporate governance implies that the company would manage its affairs with diligence. . and would maximize shareholder wealth. transparency.
26 Theories of Corporate Governance The agency theory The stewardship theory The stakeholder theory The political theory .
. 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 27 Companies are needed to at least have policies and practices in conformity with the requirements stipulated under Clause 49 of the Listing Agreement.
companies should form a Shareholders’/Investors’ Grievance Committee under the Chairmanship of a non-executive independent director. . Shareholders’/Investors’ Grievance Committee As a part of corporate governance. and it’s a very powerful instrument of ensuring good governance in the financial matters.Corporate Governance 28 Audit Committee The appointment of the Audit Committee is mandatory.
Corporate Governance 29 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.
Auditors’ Certificate on Corporate Governance The external auditors are required to give a certificate on the compliance of corporate governance requirements. . 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.Corporate Governance 30 Communication The quarterly.
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