Chapter - 35

Shareholder Value and Corporate Governance

Chapter Objectives
 Review the implications of financial theory for

the corporate finance policies.  Emphasise the need for a linkage between the financial policies and strategic management.  Explain the implications of sustainable growth model.  Focus on the shareholder value creation.  Develop a framework for the shareholder value analysis.  Discuss the concept of economic value added (EVA) and market value added (MVA).
Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. 2

Financial Goals and Strategy
 Two important tasks of the financial manager

are:
 

allocation of funds (viz. investment decision) and generation of funds (viz. financial decision).

 The theory of finance makes two crucial

assumptions to provide guidance to the financial manager in making these decisions.
 

The objective of the firm is to maximise the wealth of shareholders. Capital markets are efficient.
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Financial Goals and Strategy
 The corporate finance theory implies that:

 

Owners have the primary interest in the firm, and therefore, the main objective of the firm should be to maximise owner’s (shareholders’) wealth. The current value of the share is the measure of the shareholders’ wealth. The firm should accept only those investments which generate positive net present values (NPVs) and thus, increase the current value of the firm’s share. NPVs of the individual projects simply add; therefore, the firm’s diversification policy does not create any ‘extra’ value. Hence it is not desirable from investors’ point of view. The firm’s capital structure and dividend decisions lose their significance as they are solely guided by efficient capital markets and management has no control over them.
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Financial Goals and Strategy
 Strategic management considers all markets, including product,

labour and capital, as imperfect and changing. Strategies are developed to manage the business firm in uncertain and imperfect market conditions and environment. It is an important management task to analyse changing market conditions and environment to make forecasts, and plan generation and allocation of resources.  There are many other influential constituents such as lenders, employees, customers, suppliers, competitors, government and society. Management develops goals and strategies which are consistent with the interests of these constituents and integrates their actions.  Contrary to the wealth maximising focus in the finance theory, strategic management is multi-dimensional; it optimises a vector of objectives for attaining the firm’s legitimation. Thus, the focus of strategic management is on growth, profitability and flow of funds rather than on the maximisation of the market value of share. This focus helps management to create enough corporate wealth to achieve market dominance and the ultimate successful survival of the firm.
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Sustainable Growth
 Financial goals are the quantitative expressions of a

company’s mission and strategy, and are set by its longterm planning system as a trade-off among conflicting and competing interests.  In practice, the financial goals system boils down to the management of flow of funds. The objectives of growth and return can assume different priorities during the life cycle of a company.  In operational terms, the financial goals of a company may be expressed as four key variables:
   

Target sales growth Target return on investment (net assets) Target dividend payout and Target debt-equity (capital structure)
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Features of Financial Goals
 In a study of twelve large American corporations, Donaldson
   

has identified several characteristics of a company’s financial goals system.
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 company’s financial goals system is a continuous process of balancing different priorities in a manner that the demand for and supply of funds is reconciled. A 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.
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 

Sustainable Growth
 Corporate managers in India consider the

following four financial goals as the most important:  Ensuring fund availability  Maximising growth  Operating profit before interest and taxes  Return on investment

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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

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Methods of Shareholder Value
 The 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
 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.
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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.  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 firm’s total value.  Subtract the value of debt from the total value to obtain the value of the firm’s 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 )

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Market Value Added
 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)

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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 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.
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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 profitability or spread Growth Investment period

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Accounting Measures of Performance
 Accounting measures, like earnings or return on

investment, however, have several problems:
 

They are based on arbitrary assumptions and policies and have scope for easy manipulability. Profits can be affected by changing depreciation methods, inventory valuations methods or allocating costs as revenue or capital expenditures without any change in true profitability. They could motivate managers to take short-term decisions at the cost of long-term profitability of the company. Managers could reduce R&D expenditure or expenditure of building the staff capability to bolster short-term profitability. This would happen more in those companies where the compensations of managers are based on short-term earnings.
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Accounting Measures of Performance
 They do not reflect true profitability of the firm. Earnings

are not cash flows. No distinction is made for the timing of earnings. Thus, earnings measures ignore time value of money and risk.  The most serious problem with accounting measures is that they might destroy shareholders’ wealth. A manager can increase earnings by undertaking investment projects that have positive returns but negative net present value. In other words, these projects earn returns less than the cost of capital. They would increase earnings but destroy shareholders’ wealth. Shareholders are not interested in growth in earnings rather they would like their wealth to increase through positive NPV projects.
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Economic Value Added (EVA)
 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
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Advantages
 

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 firm’s economic profit. Hence, it influences and is related to the firm’s value.
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EVA Adjustments
       

Impaired or Non-performing Assets Research and Development Deferred Tax Provisions LIFO Valuation of Inventory Goodwill Leases Restructuring charges

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Evaluation of M/B and EVA
 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.

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Value Drivers
 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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Corporate Governance
 Corporate governance implies that the company

would manage its affairs with diligence, transparency, responsibility and accountability, and would maximise shareholder wealth.  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.
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Corporate Governance
 Audit Committee  The appointment of the Audit Committee is

mandatory, and it’s 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.
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Corporate Governance
 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.
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Corporate Governance
 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.
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