CH 35

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 2
Vikas Publishing House Pvt. Ltd.
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.

 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.
 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. Financial Management, Ninth Edition © I M Pandey 5
Sustainable Growth
 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 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)
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.
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

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
 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.
 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.
 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
 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)
 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)
 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

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.
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.

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
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.
EVA Adjustments
 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
 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
 Drivers of EVA or Value based on the
Discounted Cash Flow Approach:
 Revenue enhancement
 Cost reduction
 Asset utilisation
 Cost of capital reduction

 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.
 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.

 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.
 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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Chapter - 35

Shareholder Value and

Financial Management, Ninth Edition © I M Pandey 3

Financial Management, Ninth Edition © I M Pandey 8

Financial Management, Ninth Edition © I M Pandey 9

Financial Management, Ninth Edition © I M Pandey 12

Financial Management, Ninth Edition © I M Pandey 13

Financial Management, Ninth Edition © I M Pandey 14

 The following are the determinants of the M/B

Financial Management, Ninth Edition © I M Pandey 15

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Financial Management, Ninth Edition © I M Pandey 22

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