2 Flashcards
What is Value Based Management (VBM)?
VBM is a management approach that focuses on maximizing shareholder value by using financial performance measures that include a capital charge for the use of capital.
VBM measures aim to align internal goals with the maximization of shareholder value.
How do VBM measures address limitations of traditional financial measures?
VBM measures overcome limitations by accounting for the cost of capital in goal setting, capital budgets, and managerial compensation.
Traditional measures may incentivize projects that increase earnings without considering efficient capital and asset use.
What is Return on Invested Capital (ROIC)?
ROIC is calculated as Net Operating Profit divided by Invested Capital, becoming a VBM measure when compared to the cost of capital.
What is Residual Income (RI)?
RI is the excess operating profits over the capital charge based on investment opportunities of similar risk, calculated as Operating Profit minus Cost of Capital.
What does Economic Value Added (EVA) represent?
EVA measures a company’s financial performance based on the residual income concept, calculated as Adjusted Operating Income minus Capital Charge.
What are the advantages of using EVA?
Advantages of EVA include:
* Summarizes wealth creation
* Encourages consideration of asset use in decisions
* Reflects management performance.
What are the limitations of EVA?
Limitations include:
* Time-consuming cash adjustments
* Susceptibility to accrual distortions
* Not predictive of future performance
* Most applicable to asset-intensive companies.
What is the cost of capital (WACC)?
WACC represents the return required by investors based on their assessment of forecast future cash flows and the risk of those flows.
How does financial accounting relate to risk?
Financial accounting primarily addresses returns through profit statements and is considered a risk-ignorant measure, weakly reporting on risk components.
What is the difference between risk and uncertainty?
Risk involves uncertain events with measurable probabilities and impacts, while uncertainty is when probabilities are unknown and cannot be measured.
What is the purpose of risk assessment?
The purpose is to measure risk based on probability and severity and prioritize risks for further analysis and management.
What are the components of the COSO (2004) ERM framework?
The components include:
* Internal Environment
* Objective Setting
* Event Identification
* Risk Assessment
* Risk Response
* Control Activities
* Information and Communication
* Monitoring.
What does risk reporting entail?
Risk reporting confirms the achievement of policy benchmarks and informs stakeholders about the effectiveness of risk management policies.
Fill in the blank: Risk is measured by a combination of the probability of a perceived threat or opportunity occurring and the ______.
magnitude of its impact on objectives.
True or False: EVA applies to all types of companies equally.
False.
What is the internal environment in the context of risk management?
It is about risk management philosophy, risk appetite of the firm, integrity and ethical values.
Why are objectives necessary in risk management?
Objectives are needed before events potentially affecting their achievement can be identified.
What are the four types of objectives in ERM according to COSO, 2004?
- Strategic
- Operational
- Reporting
- Compliance
How does ERM help entities achieve their objectives?
- Aligning risk appetite and strategy
- Enhancing risk response decisions
- Reducing operational surprises and losses
- Identifying and managing multiple and cross-enterprise risks
- Seizing opportunities
- Improving deployment of capital
What is a disadvantage of ERM?
Complex to administer.
What are some common types of risks?
- Commercial
- Financial
- Operational
- Strategic
- Management
- Competition
- Product
- FX risk
- Interest rate risk
- Commodity risk
- Credit risk
- Liquidity risk
- Pension risk
- Crime / people risk
- Regulatory / legal risk
- External events and catastrophic risk
What are some drivers of risk and uncertainty?
- Globalisation & Competition
- Technology
- Changing markets
- Regulation
- Human factor
What are the top five risks identified by Vodafone in their 2019 Annual Report?
- Cyber threat and information security
- Adverse political and regulatory measures
- Global economic disruption/ adequate liquidity
- Geo-political risk in supply chain
- Digital transformation and simplification
What factors affect a company’s risk appetite?
- Industry
- Culture
- Competitors
- Objectives pursued
- Financial strength and capabilities
How does a transport company like Stage Coach manage oil price risk?
By hedging the price of oil through derivatives.
What role do accountants play in risk management?
- Stimulate & support risk consciousness
- Undertake internal audit & review
- Evaluate specific risks
- Incorporate risk into decision support
- Use risk management to enhance value
What is the primary risk response decision?
To decide whether to avoid or accept the risk.
What does avoiding a risk typically mean?
Not undertaking the business activity that generates that risk.
What are the general response approaches to risk?
- Prevent
- Control
- Diversify
- Transfer or finance
What is the purpose of joint ventures (JVs) in risk management?
To hedge between technologies and as a lower cost alternative than a takeover.
What type of risks are typically managed by insurance?
Pure risks.
What is the focus of Value Based Management (VBM)?
Improving shareholder value.
What are some conditions under which firms are more likely to hold managers accountable for the cost of capital?
- Firm’s strategic importance to use assets intensively
- Influence of managers on VB performance
- Delegation of strategic & operational decision rights
Fill in the blank: VBM measures may not be effective if managers do not have an influence over the _______.
cost of capital.
True or False: VBM measures completely replace traditional financial measures.
False.
