Exam Questions - Chapter 1 - November 2020 - Question 2 Flashcards
Organisations serve to meet the needs of multiple stakeholder groups, both internal and external.
Candlewick has surveyed its customers with regard to the potential expansion into beeswax pillar candles.
Analyse Candlewick’s key stakeholders (including shareholders) and the perception that these stakeholders might have of the risks regarding this potential change in business strategy.
Your answer should take into account the type of stakeholder and their general propensity for taking risk, i.e. are they ‘risk seeing’ or ‘risk averse’.
Answers should define stakeholders and consider some of Candlewick’s stakeholders and stakeholder groups.
The different stakeholders should be identified and their ‘stake’ or interest in the organisation noted in relation to the case study.
Answers could include the following content:
All organisations serve to meet the needs of multiple stakeholder groups, including consumers, creditors, owners, shareholders and third parties. For Candlewick, in relation to both their suppliers and customers, these stakeholders come mainly from the UK (60% of their sales), but also from different countries in Western Europe, especially in relation to the new manufacturing site being built in Stuttgart.
Meeting the needs of these stakeholders regarding risk, or more specifically the risks they may want an organisation to take and the risks that they do not wish it to take, is a key way in which risk management can create and preserve value.
Organisations meet the needs of their stakeholders through setting objectives that provide an appropriate balance between risk and return and by ensuring that these objectives are achieved. This includes managing the risks which may threaten the achievement of these objectives, such as competition or compliance risks. How an organisation balances risk and return, and the degree to which it manages the risks associated with implementing its objectives, will depend on the risk attitudes and preferences of these stakeholders.
Candlewick are expanding both geographically (Stuttgart) and in their product base (beeswax pillar candles) and should be considering their stakeholder’s expectations in developing and delivering on their objectives.
Figure 1.1 could be included in answers as it illustrates the main stakeholder groups that have an explicit or implicit contract with a typical organisation. Whether this diagram is used or not, it should be made clear in the answer that there are external and internal stakeholders. The stakeholders in the outer ring are termed external stakeholders because they are outside the organisation. The stakeholders in the inner circle are termed internal stakeholders because they are employed by or own the organisation.
Each of these stakeholder groups ‘invest’ in the organisation with their time, skills, money or something less tangible like their health and wellbeing. Stakeholders expect returns like salaries (employees), safe and reliable products and services (customers), or interest payments to meet the cost of these investments (shareholders). They also expect the organisation to be managed in such a way that these returns are delivered in a consistent manner without any unpleasant surprises. For example, employees will expect the organisation to remain in business to ensure that their salary is paid. They will also expect to be kept safe when at work. Customers expect to receive goods and services that are safe and reliable and expect product guarantees to be honoured.
The fire at the competitor company will be a key point of interest to investors, customers and employees alike, as well as Candlewick’s insurers. The Board also wants more assurance that Candlewick is not vulnerable to the same situation and the same outcome as its competitors.
In all cases, each group wants to be reasonably assured that the agreements and reasonable expectations are being met. Effective risk management supports this.
Shareholders and owners are less easy to classify. For large quoted companies, such as public limited companies, they are generally viewed as external stakeholders. For smaller companies with smaller numbers of owners or partners, especially where these owners are involved in the management of the organisation, they are considered to be internal.
Stakeholders who will have an interest in the expansion of the business into pillar wax candles will be internal and external, but in particular the potential customer views are important and those of shareholders who are looking for a return on their investment.
As noted in the study text, most stakeholders are inherently risk averse. Stakeholders prefer certainty to risk and will sacrifice some of their wealth or income to achieve this certainty. Like any other stakeholder, the average shareholder is inherently risk averse but that does not mean they will demand the same level of risk reduction as other stakeholder groups. This is because shareholders have different objectives to some other stakeholder groups and because they have their own tools to manage risk.
The shareholder perspective on risk management, and why they may not behave in a risk averse way can be related to the three following reasons:
Asymmetric returns: shareholders many receive dividends and they may benefit from an increase in the value of the shares that they hold, allowing them to be sold for a profit. Generally, risk and return are positively correlated. The more risk an organisation takes, the more return it can generate: a return that should translate into increased dividends and share values. Shareholders may value an increase in risk, providing that there is the prospect of higher returns. Such an increase in risk may result in a higher chance of bankruptcy, but shareholders are often protected from this because of their limited liability. The diversification into beeswax pillar candles should increase dividends as the market is expected to grow annually by 9% to 2025
Limited liability: the shareholders of most companies, whether public or private limited companies, have limited liability. In the event that the company becomes insolvent or goes bankrupt, shareholder liability is limited to the value of their investment stake. Limited liability shareholders cannot be forced to provide additional funds once they have invested in a company, as would be the case if shareholders had unlimited liability. It is not expected that Candlewick will become insolvent or bankrupt, however, there is a risk in moving in a new area of the market and in acquiring a new business.
The diversification of risk: shareholders often choose to create diversified portfolios of investments. They purchase shares in multiple companies or some other form of investment asset (for example, bonds, commodities or property). Through diversification, shareholders can insulate their investment portfolio from company-specific risk events such as fires, frauds or a decline in sales. Diversification can be understood via the well-known proverb ‘do not put all your eggs in one basket’. This will be a positive aspect of the business strategy for shareholders as Candlewick will be diversifying into new forms of candles (pillar as well as container candles) and they will also be providing manufacturing and distribution of candles in Europe, that may help with some of the political risks from Brexit, environmental concerns, and so on.
These three factors mean that shareholders may also behave in a risk neutral or risk preferring way, rather than risk averse. It is expected that the definitions of these terms should be provided in the answer:
Risk averse - ‘A reluctance to take or to be exposed to risk. Individuals, groups or organisations that are risk averse will, all things being equal, prefer certainty to risk and will typically require some form of financial premium in order to take risk.’
Risk neutral - An indifference to risk. A risk-neutral individual, group or organisation will be unconcerned about exposure to risk and is indifferent to risk or certainty, providing the expected returns from these two different states is identical.
Risk preferring - A liking for risk and risk taking. Individuals, groups or organisations that are risk preferring will, all things being equal, prefer risk to certainty and will typically pay a financial premium or suffer some other kind of non-financial cost (such as to their health) in order to take risk.
It is not often that shareholders will behave in a risk preferring way as this can lead to bankruptcy and is blamed for the financial crisis in 2007-2008. It is unknown, which of these preferences Candlewick holds, either individually or as a group, however, in most cases, as with Candlewick, shareholders will value effective risk management and will expect that Candlewick will have carried out risk management activities to ensure that its decisions to expand are sound.
Just because stakeholders are typically risk averse, that does not mean that they will be averse to the same risks or have equal levels of risk aversion. Conflicts regarding the preferred type and level of risk exposure may arise.
Where conflicts exist between stakeholder groups, risk management takes on a new objective: to further protect and create value by managing these conflicts and increasing the overall level of stakeholder satisfaction. Effective risk management is needed to help balance the conflicting interests of different stakeholder groups, weighing up different priorities and assessing the costs and benefits of different risk management decisions and risk exposure levels. The Board and senior management are very important here, as they are the ones who have to make these difficult decisions. These decisions will influence the riskiness of the strategy that the Board chooses for the organisation, along with the level of investment in risk management to help ensure that organisational objectives are met. Company secretaries and other governance professionals (as well as an organisation’s specialist risk management staff, where present) have a role to play in supporting these decisions to ensure that any legal, regulatory or ethical concerns are considered.
Given that there is a conflict of interest between Candlewick’s Board members regarding risk management and the information being shared at Board level, the Company Secretary will have a greater role in ensuring the full range of principal risks are being identified across the organisation and being raised to senior management and Board level for appropriate consideration in strategic decision-making generally, and around the potential acquisition of Bees Knees.
