CHAPTE SHAREHOLDER VALUE AND CORPORATE

R 35 GOVERNANCE
 LEARNING
2
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
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STRATEGY
 Financial 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.
 Characteristics of a company’s
financial goals system
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(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 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.
 Cont…
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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.
Corporate managers in India consider the
following four financial goals as the most
important:
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 Ensuringfund availability
 Maximizing growth
 Maximizing operating profit before interest and
taxes
 Maximizing return on investment
 SHAREHOLDER VALUE
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CREATION
 Thevalue 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
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 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.
 Methods of Shareholder Value
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 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.
 Methods of Shareholder Value
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 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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 Interms 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 firm’s economic profit. Hence, it
influences and is related to the firm’s 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 
 MANAGERIAL IMPLICATIONS
OF SHAREHOLDER VALUE
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 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.
 Cont…
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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.
21

BALANCED SCORECARD
 Should a balanced scorecard
always
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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.

 The balanced scorecard is a critical component of the

strategic planning process which involves creative
thinking, communicating, sharing, informing, analyzing,
understanding, etc.
 Conditions necessary for
Implementing Balanced
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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
 Significance of the Balanced
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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.
 Theories of Corporate
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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 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.
 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.