Corporate restructuring and Strategic Financial Management

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 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.
 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 a 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.
Contd..
 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.
 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.
Contd..
 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.
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.
Contd..
 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.
Contd..
 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
Contd..
 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 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.
Contd..
 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
 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 –
invest 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.
Contd..
 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.
Contd..
 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
 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.
Contd..
 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

 Audit Committee
 The appointment of the Audit Committee is
mandatory, and it’s a very powerful instru -
ment 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 independ-
ent director.
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.
Contd..
 Management Analysis
 Management is required to make full
disclosure of all material information
to investors.
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.