The Interdependencies Between Corporate Governance, Fair Value and Firm Value

In India, the basic framework of corporate governance was introduced in the Companies Act, 1956. Over time, this has been strengthened with inputs from various committees and regulatory bodies such as revisions to Clause 49, introduction of the Companies Act 2013 and more recently the Kotak Committee report which was institutionalized to advise on new imperatives on corporate governance. In the last few years, corporate governance has assumed greater importance as quite a few governance transgressions have been reported. In this context, Varun Gupta, Managing Director, India and APAC Leader for Valuation Services, Duff & Phelps establishes the importance and correlation between the value of a firm and the rigor of its corporate governance practices.

 

What is Corporate Governance?

Broadly speaking, Corporate governance is a set of rules, practices and policies that dictates corporate behavior. Boards of directors, shareholders and management act as the three pillars of the framework, with the Board acting as the chief custodian. While it is difficult to put together a comprehensive definition of what constitutes good corporate governance, the lack of corporate governance can often manifest itself in the form of corporate failures resulting in substantial losses to investors.

 

Impact of Good Corporate Governance on the Value of a Firm

Corporate Governance primarily addresses the “agency problem” ensuring that the “agents”, i.e., the management acts in the best interests of the “principals”, i.e., the shareholders. In the Indian context, where promoters often don the hat of the management, protecting minority shareholders’ interest is key to a good corporate governance framework. It helps bridge the information asymmetry between promoters and other shareholders, while giving confidence to minority shareholders that they will not be taken for a ride.

Not only is it intuitive, but also various researchers across the world have found positive correlation between good corporate governance and superior market returns. It has also been established that there is a causal link between good corporate governance and lower cost of capital, effective capital allocation and risk management, among other benefits.

 

Correlation Between Fair Valuation and Corporate Governance

Transparency and disclosure are the key ingredients of good corporate governance, which comes from a company’s willingness to disclose the critical details that can help an investor make an informed decision. In financial reporting, the new Indian Accounting Standards (Ind AS) have put a lot of emphasis on disclosure as well as recognition of assets and liabilities at fair value.

As per Ind AS, “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.

Fair value represents a realizable value in a hypothetical transaction scenario as of a specific date. Compared to the traditional historical cost, fair value gives a truer picture of the assets and liabilities of a business.

While fair value ensures that assets and liabilities presented on the balance sheet are not disconnected to their market value, it is also dependent on the control environment. Estimation of fair value is contingent on certain forward-looking management assumptions, which can be abused in absence of the right control environment and good corporate governance.

 

Relevance of Fair Value in Deals

In case of any corporate actions such as mergers, acquisitions, capital reduction, etc., resulting in change in shareholding pattern, it is the fiduciary responsibility of the board of directors to protect shareholders’ interest by ensuring fairness of the transaction. For Schemes of Arrangements involving listed entities, it is mandated by SEBI to seek a ‘fairness opinion’ by a SEBI registered merchant banker. Fairness Opinion is an independent opinion that boards of directors ask for, while contemplating a major corporate transaction to make sure that the transaction is not tilted towards a particular segment of shareholders. This serves as a professional opinion whether the proposed transaction is fair to all shareholders, which is critical for fostering an environment of trust among investors. With the new Companies act placing more and more responsibilities on directors, there is greater consciousness on corporate governance to protect minority shareholders and there is rising interest and relevance for this practice in India.

The Interdependencies Between Corporate Governance, Fair Value and Firm Value 2019-06-19T00:00:00.0000000 /insights/publications/valuation/interdependencies-corporate-governance-fair-value-firm-value /-/media/assets/images/publications/valuation-advisory/interdependencies.ashx publication {B062D54C-1425-4A04-8F9F-95EA14068E6D} {E010DCD9-B7BA-4B98-9F3C-A51506B5C1D8} {51947818-C499-4911-9447-3AA383066F9E}

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