CHAPTER 35

SHAREHOLDER VALUE AND CORPORATE GOVERNANCE

Q.1.
A.1.

Describe the interface between financial policies and corporate strategy.

In practice, financial policy of a company is closely linked with its corporate
strategy. A firms strategy establishes an effective and efficient match between its
competences and opportunities and environmental risks. It provides a mechanism
integrating the goals of its multiple constituencies. Financial policies of the firms
should be developed in context of its corporate strategy. Within the overall
framework of the firms strategy, there should be consistency between financial
policiesinvestment, debt and dividend. For example, a firm may be able to
sustain a high-growth strategy only when its investment projects generate high
profits and it follows a policy of low payout and high debt.

Q.2.
A.2.

What is sustainable growth rate? What factors determine it?

Sustainable growth may be defined as the annual percentage growth in sales that
is consistent with the firms financial policies (assuming no issue of fresh equity).
The following formula can be used to determine the sustainable growth (gs) in
sales:
net margin retention leverage
sustainable growth =
assets turnover (net margin retention leverage)

gs =

PAT/S RE/PAT (1 + D/E)

NA/S [PAT/S RE/PAT (1 + (D/E))]
gs =

pbl
a ( p b l)

where p = net margin = PAT/sales, b = retention ratio = retained earnings

(RE)/net profit (PAT), l = leverage = net assets (or capital employed) to equity
(net worth) = (1 + D/E), and a = asset-output ratio = net assets/sales.
The net assets to sales ratio determines the requirement of funds to be
invested in assets to support a given level of sales. The requirement for funds
would increase with expanding sales. The net profit minus the dividends is an
internal source of funds. Thus, the product of net profit to sales ratio and retained
profit to net profit (net margin retention ratio) gives an idea of the funds
available internally to support the growth of the firm. Retained earnings increase
the debt raising capacity of the firm. Thus, given the target capital structure, the
total funds would be equal to retained earnings plus debt supported by the
retained earnings [viz., pb (1 + l)]. Net assets or capital employed (viz., debt plus
equity) to equity is a leverage measure, and is equal to one plus debtequity ratio.
Q.3.
A.3.

What is shareholder value analysis? What relationship exists between growth,

economic profitability and the shareholder value?
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. Thus, shareholder
value is:
Shareholder value = Market value of the firm Market value of debt
The market value of the shareholders equity is directly observable from
the capital markets. In theory, the market value should be equal the warranted
economic value of the firm. The true economic value of a firm or business or
division or project or any strategy depends on the cash flows and the appropriate
discount rate (commensurate with the risk of cash flows).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.
Three most commonly advocated methods of shareholder value creation
are as follows:
The first method, called the free cash flow method, uses the weighted
average cost of debt and equity (WACC) to discount free cash flows. Free cash
flows are calculated as follows:
FCF = PBIT(1 T) + DEP ONCI NWC CAPEX
where PBIT = profit before interest and tax, T = corporate tax rate, DEP =
tax depreciation, ONCI = other non-cash items, NWC = change in net working
capital (i.e. stocks plus trade debtors minus trade creditors), and CAPEX =
incremental investment.
The second method calculates the economic value of a firm or business in
two parts: the economic value of unlevered firm and the economic value of the
financing effects. The value of an unlevered firm over its planning period is given
as follows:

FCFt
TVn
+
t
t =1 (1 + k )
(1 + k u ) n
u
n

Vu =

Notice that ku is the cost of capital of an unlevered firm. For the levered
firm, the second part includes the value of interest tax shield (VITS):
n

VITS =
t =1

ITS t
(1 + k d )

Thus, the value of a levered firm or business is:

Value of a levered firm = Value of unlevered firm + Value of interest tax
shield
We can obtain the warranted value of shareholders equity as the
difference between the economic value of the firm and the claims of debt holders.
The value per share (VPS) can be obtained by dividing the value of shares (E) by
the number of shares (N):
E
VPS =
N

The third method for determining the shareholder economic value is to

calculate the value of equity by discounting cash flows available to equity
shareholders by the cost of equity. The equity cash (ECF) flows will be equal to

free cash flow plus after-tax interest:

Equity cash flows = (PBIT INT )(1 T ) + DEP ONCI NWC CAPEX

= PBIT(1 - T) + DEP ONOCI - NWC - CAPEX - INT(1 - T)

= FCF + INT(1 - T)
Equity cash flows are net of interest charges and investments, and,
therefore, at the corporate level they coincide with dividends. Equity cash flows
reflect the expected growth in future cash flows. At the end of the planning period
(the term of investment), the terminal or residual value of investment will have to
be estimated. The economic value of equity is given by the discounted value of
equity cash flows plus the present value of terminal value.
Q.4.
A.4.

Define MVA? How is it calculated? What are its pros and cons?
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 value is also referred to as the enterprise value. It is the total of
the firms market value (MV) of debt and market value of equity. MVA may also
be calculated as the difference between market value of equity and invested equity
capital. Managers must aim at earning higher MVA for shareholders.
There is conceptual problem with MVA. Invested capital is at historical
value. Considering the alternative opportunities of equivalent risk, the economic
value of the invested capital would be much higher today. Yet another problem
with MVA is that it ignores cash flows received by shareholders in the form of
dividends and share buyback and cash contributed by them as additional share
capital.

Q.5.
A.5.

What is economic value added? How is it calculated?

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 use equity capital
= PAT - cost of equity equity capital
In a divisionalized company, the separate information about the debt and
equity may not be available. Hence there is a popular alternative way of
calculating EVA in such situations as given below:
Economicvalue added = Net operating profit after tax - charges of invested capital
or capital employed = EVA = NOPAT - COCE
Here NOPAT is profit after depreciation and taxes disregarding interest on
debt. EVA can be calculated as the difference between ROCE and WACC
multiplied by invested capital or capital employed:
EVA = (ROCE - WACC) CE

Q.6.

What are the advantages and disadvantages of economic value added? Is it a

A.6.

Q.7.
A.7.

superior method of performance evaluation than return on capital employed?

How?
The advantages of EVA over the market-based and accounting-based measures of
value creation are as follows:
1. EVA can be calculated for divisions and even projects.
2. 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.
3. 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.
4. EVA is a measure of the firms economic profit. Hence, it influences and
is related to the firms value.
From the accounting perspective, a firm is profitable if its return on equity is
positive. However, from an economic perspective, the firm is profitable if the
return on equity exceeds the cost of equity, or return on capital employed exceeds
the over-all cost of the total capital employed.
The EVA approach uses the accounting-based net operating profit after tax
while the cost of capital is market determined. EVA is biased because it uses
accounting earnings (NOPAT or PAT) which are based on arbitrary assumptions,
allocations and accounting policy changes. It also does not include changes in
working capital and capital expenditures. Therefore, the measure of EVA is not
equivalent to cash flow from operation, although with adjustments to accounting
profit it comes closer to cash flows.
Define corporate governance. Describe the attributes of a good corporate
governance system.
Corporate governance implies that the company would manage its affairs with
diligence, transparency, responsibility and accountability, and would maximize
shareholder wealth. Hence it is required to design systems, processes, procedures,
structures and take decisions to augment its financial performance and stakeholder
value in the long run.
Good corporate governance requires companies to adopt practices and
policies which comprise performance accountability, effective management
control by the Board of Directors, constitution of Board Committees as a part of
the internal control system, fair representation of professionally qualified, nonexecutive and independent Directors on the Board, the adequate timely disclosure
of information and the prompt discharge of statutory duties. In fact, companies are
needed to at least have policies and practices in conformity with the requirements
stipulated under Clause 49 of the Listing Agreement.