Corporate Governance and Value Creation Relationship

Corporate Governance and Value Creation Relationship Department of Economics VALUE CREATION AND THE ROLE OF CORPORATE GOVERNANCE Abstract Corporate Governance is a subject of many professional and academic debates. Since there are many different research and contexts associated with corporate governance problem, then, this topic has continued to be an interesting topic under scrutiny. However, is has been observed that the relationship between corporate governance and value creation of corporation remains as an untapped area with enough consideration. This paper tends to investigate this linkage and using Enron case as critical analysis. TABLE OF CONTENTS (JUMP TO) 1. Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2. Literature Review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3. Corporate governance and performance of the company . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3. 1. Definition and explanation of key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3. 1. 1. The concept of corporate governance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3. 2. 2. The concept of value creation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 3. 2. 2. 1. Definition of value creation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 3. 2. 2. 2. The importance of value creation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3. 2. 2. 3. Measuring Value-creation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 3. 2. The impact of corporate governance in the Value Creation. . . . . . . . . . . . . . . . . . . . . . . . . . 17 4. The role of finance in creating value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 4. 1. The principles of management by the financial value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 4. 1. 1. The principle of double market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 4. 1. 2. The principle of identifying financial levers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 4. 1. 3. The principle of internal steering. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 4. 2. The mechanisms and the extent of creating value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 4. 2. 1. The economic indicators. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 4. 2. 2. The indicators such as accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 4. 2. 3. The nature of stock market indicators. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 4. 3. The limits of management by the financial value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264. 3. 1. Scope limited and performance standards unrealistic. . . . . . . . . . . . . . . . . . . . 26 4. 3. 2. Transfer of risk to the employee shareholder. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 4. 3. 3. Focus on short-term and limits the cost of capital. . . . . . . . . . . . . . . . . . . . . . . . 27 5. Critical approach to corporate governance: the case of Enron. . . . . . . . . . . . . . . . . . . . . . . . 29 5. 1. Introduction of the Enron affair. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 5. 2. Enrons scandal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 5. 3. The consequences of this scandal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 5. 4. The lesson from Enron Case. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 6. Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 7. Further study recommendation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 List of Abbreviations NGO Non- Governmental Organization US United State CEO Chief Executive Officer BOD Board of Directors COO Chief Operating Officer CFO Chief Financial Officer CRO Chief Risk Officer CFROI Cash Flow Return on Investment EVA Economic Value Added RCF Residual Cash Flow DCF Discounted Cash Flow CVA Cash Value Added RAN The Rainforest Action Network MFV Management by the Financial Value TSR Total Shareholder Return MVA Market Value Added NPV Net Present Value EPS Earnings per Share ROE Return on Equity EROR Economic Rate of Return PBR Price to Book Ratio 1. Introduction The successive industrial revolutions of the late eighteenth and nineteenth century were a major factor for the development of Western capitalism and gave gradually traits that characterize it today. In this movement, the company as a structure that brings together human beings who are organized to act on nature to obtain useful results and thus create value has always been at the heart of the capitalist system. However, in recent decades, many changes have affected the financial-market capitalism and gave new prominence to creating value for shareholders of the company. This has resulted in the emergence of a form of management oriented to advance the financial value and mobilize employees to that goal. This focus on value creation reflects a desire to meet the requirements of the shareholder because it has become in the current financial world a king increasingly adulated and increasingly capricious. Undoubtedly, this logic has largely influenced the conduct of the strategy of com panies that demonstrate ingenuity to cope with competition and remain competitive. However, it has undergone profound questioned at a number of scandals that have marked with an indelible history of finance and have been accompanied by strengthening institutional mechanisms for regulation of businesses and financial markets. In such a context of questioning, suspicion and doubt in respect of managerial practices, questions about the role of governance and firms value creation does it not absolute importance to apprehend the changes that occurring within the company? The aim of this paper is to answer this question. The structure of the paper is organized as follows. Section 1 provides a background of what has been done in the literature in the effort to capture relationship between corporate governance and value creation. Section 2 introduces the key concepts such as corporate governance and value creation. Section 3 illustrates the role of finance in creating value in firms. Empirical approach are presented and discussed in section 4, with special stress on the managerial behaviour in Enrons Company. Section 5 will conclude and propose further areas of research. 2. Literature review On the topic of relationship between corporate governance and value creation, there have been various researches and conclusions. Before examining about the relationship between corporate governance and value creation, many early studies has explored the linkage between Ownership and Value Creation as a beginning. Talking about owners who have been passionate about their ideas and visions to create the best value for their company, study named Ownership and Value creation of Carlsson. R. H (2001) gave a valuable historical review and illustration with case how active ownership has played an important role in company development. Through this book, we can see that ownership makes significant differences in corporate governance, it fulfils an indispensable role in the market and its quality made firm the best value. Later, in his research Corporate Governance and Value Creation, Jean-Paul Page (2005) has referred to the financial approach to corporate governance in his analysis. He has explored the connection between the foundation of power and decision making to create the large value for firms. In order to focus on an in-depth analysis of the links between value creation and governance, his research started with the assumption that regulation and laws exist to constrain corporate activities which could harm society as well as the economy, then corporate agreement is expected. Through a research, he tried to find the answers of who should hold the ultimate power which companies can create maximum value or how this power should be used. To do this, first, he discussed the delegation of shareholder power and a variety of standard to evaluate the performance of managers. Then, he presented a framework by which securities analysts can evaluate corporate governance system. As the result of his study , he strongly believed that directors of companies have the necessary judgment to discharge their value creation responsibility. Jean-Paul Page result is developed further in detail by Monks (2002) when he applied this theory into Volkswagen Company. After that, Huse (2007) successfully combines the behavioural of directors work and the value creation which contributes to both the practitioner and the academic debate. Huses book is based on two key ideas: the main task of a broad of director is to create value for company and looking inside board to understand the value creation process needs. His book provided a good discussion about governance effectiveness and value creation by an exploration of behavioural perspectives on governance and how various types of related factors influence governance as well as value creation. In addition, in his recent research named The Value Broad: Corporate governance and organizational behaviour in 2008, he aimed to go further and explore actual behaviour in creating value from entrepreneurial management perception throughout various European countries such as Netherlands, Italy. Beside, The differentiated Network: Organizing Multinational Corporation for value creation of Nohria. N and Ghoshal. S (1997) was successful to present the globally distributed capabilities of multinational corporations and organize these corporations for value creation. This study is built to develop these ideas of both authors above. Besides theoretical research and studies, many case studies were analysed to examine the implication of all theories in the real economic market. Case study in Finances: Managing for Corporate Value Creation of Bruner. R. F (1990) provided numerous financial analyses of the world famous and successful corporations such as Walt Disney, Atlantic Southeast Airlines, Morgan Stanley Group INC, Merit Marine Corporation. . . However, this analysis was published in 1990, it can not update with changes in the economy as well as financial scandals have been happened through recent years. Based on all these suggestions, an analysis of value creation and the role of corporate governance is an interesting paper. And Enrons scandal in 2001 is an updated illustration. 3. Corporate governance and performance of the company 3. 1. Definition and explanation of key concepts 3. 1. 1. The concept of corporate governance We can consider that the practices of corporate governance have ancient origins insofar as they are inseparable from the very concept of enterprise. Indeed, corporate governance problem was already in the eighteenth century. Adam Smith posed as soon as 1776, in the Wealth of Nations, the problem of separation of interests between managers and owners in companies per share. This question will take a new turn with the emergence in 1807 in France and then England with the Company Act and a little later the United States, the limited liability company. In general, governance refers to the governing relations between the leaders of a company more broadly, an organization and the parties concerned by the fate of the so-called organization, mainly those who hold legitimate rights - namely shareholders. Even if made generally and in order to illuminate our analysis, such a definition requires clarification. First, governance is focused on a category of actors of any organization: the lea ders of this organization, category sometimes reduced to a person, most often represented by a small group strongly hierarchical around the leader, sometimes expressed by semi-hierarchical and ill-defined contours. Whatever the difficulties of defining exactly and narrow, this category of actors always pay attention on a system of governance. Corporate governance can be seen as vast field and its works as regulatory body that includes (OECD, 2004): Chief Executive Officer (CEO) Board of Directors (BOD) Management of Organization Shareholders Stakeholders (Suppliers, Employees, Creditors, Clients and Social Communities) Then, the issue of governance is also the role and control of corporate officers in legal persons. The leaders of an organization finalized commercial, public . . . Speak and act on behalf of this organization: a title that they can buy, sells, hire, dismiss and so on. They have before it the financial, material, human, which can be considerable even excessive. Issues relating to their appointment as corporate officers, the conditions for exercising their mandates are, therefore, legitimate and make corporate governance a key point of management systems of the latter. Finally, the governance system includes various components that can be, simplifying, grouped into three sets of components: structures, procedures and behaviour. The structures involved in the governance system are varied. Some are specific to the organization concerned: general meeting, board of directors, ad hoc committees. Others are external and intervene on the basis of contractual missions (auditors, rating agencies) or as part of missions of general interest (regulatory authorities). The procedures are also very varied and more or less diversified in codes or codes imposed on the actors involved (chart of accounts, commercial code . . . ). They may involve both methods of collection and dissemination of information on the functioning of the entities concerned that ways and means to carry out such an operation such as changing the parameters of the structure or listing on the financial market. The behaviour complements the first two components by providing a dimension without which they would remain for the most formal. Such behaviour are those agents individuals is not the legal fiction made up by legal persons involved in the institutional and responsible to implement it and animate it. Therefore, their best practices, their ethics or, conversely, their lack of scruples and their departures were a major part in the effectiveness of governance systems like any human system. In their brilliant literature review of corporate governance topic, Shleifer and Vishny (1997) offered a definition of corporate governance: Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment (p. 737). This notion of governance seems rather simplistic. Because it is limited to the individual control worked out by shareholders and ignores the rights of all the other stakeholders in the company such as creditors, suppliers, customers, employees, and finally, the State and society in general. Indeed, the shareholder affects some form of power and imposes limits in varying degrees that affect value creation. Besides, this definition of governance fails to take into account the implicit rules and standard such as legislation, regulations and contracts. All these things actually have an important influence on final decision. In his book, Jean- Paul also gave the broad definition of corporate governance as follows: Corporate governance consists of the legal, contractual, and implicit frameworks that define the exercise of power within a company, that influence decision making, that allow the stakeholders to assume their responsibilities, and that ensure that their rights and privileges are respected. (pp. 2) To be successful in this notion, corporations must acquire the best resources such as: finance, material and human at the best if they want to create value or wealth. Good corporate governance is assessed in a book named Corporate Governance: Responsibilities, Risk and Remuneration, Keasey. K and Wright. M (1997) He defined a good corporate governance is as concerned with correctly motivating managerial behaviour towards improving the business, as directly controlling the behaviour of managers. They also analysed executive remuneration is one mean of motivating good behaviour. Illustrating the standard corporate governance frame work, both authors above indicated that the key elements concern the enhancement of corporate governance is via supervisors of management performance and ensuring the accountability of management to shareholder and other stakeholders. Analysis of a frame work of corporate governance was also carried by Hart (1995). He discussed the need for accountability and supervisor of director come up because there is a divorce between ownership and control power in large firms. According Harts study, supervision may take various forms ranging form system where shareholders are outsiders with little direct incentive to monitor management. Moreover, Whittington (1993) argued that is has to be noted that the accountability and supervision aspects take place within a wider regulatory framework which regulates relationship with external third party contractors. 3. 1. 2. The concept of value creation 3. 1. 2. 1. Definition of Value Creation As for value creation, it is an ambiguous concept because of the multiplicity of managerial practices associated with it: exchange value, book value or economic value partnership, value for the customer, and so on. In all case, the most important objective of every firm is to maximize resource allocation, to produce as much economic value as much as possible and to look up social well-being. Offering the best product and services at reasonable price is the way which firms can do to achieve these objective above. Jean-Paul Page (2005) examined economic value as creating wealth. Because the firms wealth is measured by the value of their product on the market, then, creating value for firm mean company will observe its prices and value increase as demand for its services and goods rises. Concisely, creating economic value means increasing in firms value, increasing in share price and creating wealth. As a result, corporate governance have to focus on decision that tend to maximize share price and then on the creation of economic value. This way will translate the wealth creation objective of firms into tangible results. 3. 1. 2. 2. The importance of value creation In his academic journal, Favaro. Khas proved that if firm puts their value creation as a first strategy, it will help a corporation growth in the greatest rate. First of all, by understanding how, why, where the value is created within your company; which is the market where your company perform best; identifying which of your companys activity and asset is distinctive enough to be a profitable growth will tell your company where and how to grow. The best example of this case, we have to mention about Coca -cola. Since the early of 1980s, Coca-colas leader discovered the value creation in their mix businesses and in the entire beverage system; then, this company have taken a major growth opportunity in their core business. Secondly, there are two advantages which putting value creation first can gives firms are: capital and talent. When firm set value creation first, they will never suffer from a capital shortage. Favaro gave explanation that, these companies which put value creation first will find sufficient capital for their investment needs and can attract a large capital from the market, and then they never miss any investment opportunities. In addition, knowing all important targets, these companies also understand how important the high standard and good qualification managers are. Therefore, over time, these firms will build a team of manager with better capabilities and standards. This will give company more managerial talent and help these companies achieve higher level of profitable and also sustainable growth than their competitors. Value creation enhances companys ability to grow up which requires perseverance Discipline and leadership skills. Through his experience, Favaro suggests that: By product, channel, customer, market and technology; skilled managers who always put value creation first will understand how or why value is created or destroyed. Then, they will know whatever cut will be the best reveal the truly capabilities or asset which their company have to do to get profitable and growth. Promoting, celebrating and rewarding managers who see growth is an outcome of their focus on value creation. Briefly, if a company put value creation first in the right way, their managers can identify how and where to grow, they will use capital better than others and build up more talents. Consequently, value creation will offer you a vast advantage to achieve profitable and long-term growth. It should be noted that these multiple approaches are experiencing varying degrees of success. Thus, while some of them are rather a fashion effect, others seem more rooted in the reality of management. This is particularly the case in the field of strategy with the general themes related to the competitive advantage that determines the value that a company can create for its customers and in the field of finance with the concept of maximizing the shareholder value. However, there are two themes refer to distinct managerial logic. In schematising, one can oppose a logic of financial reform dominated the creation of financial value and logic of integration that connects the various aspects of value creation. The financial approach emphasizes the idea that any asset is comparable, at least conceptually, a financial asset whose correct measure is the present value of expected flows of that asset, given the risk that it is linked. Thus, by analogy with financial assets, it is possible to buy or sell at any time comparable assets or reinvest the funds on other opportunities. The option is part of choice and is a factor of flexibility. The logic of integration recognizes the importance of value creation but the analysis as the result of a synthesis of different components of value, whether organizational aspects, competitive or institutional. It puts forward concepts such as basic skills, know-how of cooperation and coordination, competitive advantage. It requires a broader view of performance and the development of a scoreboard, including non-financial aspects. This concept of value creation is currently experiencing a revival and for several reasons. This renewal first undoubtedly result of the transformation of financial capitalism and its origin movements takeover carried out on companies that exploitation not effectively their asset base for shareholders. These practices have provided external visibility to market discipline that has prompted leaders to do more attention to creating value and bring back the shareholder at the centre of the strategy. In addition, development of globalization and the rise of new technologies of information and communication technologies have accelerated the process of internationalization of enterprises and networking complex and globalize. The result is a financial reform of the strategy based on the refocusing on the principal market and the pursuit of critical size. That is why the purchase of shares and options markets external growth is systematically privileged at the expense of endogenous development of the company. But for institutional investors, who control more companies using their power, the ability of business to create value is an essential criterion of assessment. Finally, another external factor that has boosted the value creation is the gradual disappearance of state monopolies especially in the case of France. The purpose of the public monopoly system based on the existence of cross-shareholdings is to ensure a stable partnership. The financial globalization has gradually reduce d the interest of a national shareholding making less essential closures capital that provides few resources. 3. 1. 2. 3. Measuring Value-creation: When evaluating value creation, there are three main measurements are: Cash Flow Return on Investment (CFROI), Economic Value Added (EVA), and Residual Cash Flow (RCF). G. Bennett Stewart III (1991). The Quest for Value. HarperCollins discussed Economic Value Added (EVA) as the heart and soul of Value planning. He described EVA is the one measure which properly accounts for all the complex trade-offs involved in creating value. EVA computed by taking the spread between the rate of return on capital r and the cost of capital c* and then multiplying by the economic book value of the capital committed to the business: EVA = (r-c*) x Capital EVA = (rate of return cost of capital) x capital EVA will increase when: The rate of return earned on the existing base of capital improves; that is, more operating profits are generated without tying up more funds in the business. Additional capital is invested in projects that return more the cost of obtaining the new capital Capital is liquidated from, or further investment is curtailed in, substandard operations when inadequate return being earned. These are the only way in which value can be created