Systems; Corporate Finance: Leveraging the Value Pentagon

TRIMILLENNIUM MANAGEMENT : CORPORATE FINANCE
Leveraging the Value Pentagon

By Prasanna Chandra

Shareholder value tops the corporate agenda. It is widely accepted that sustained value creation alone can ensure the viability of an organisation and protect the interests of all its stakeholders. Translating this intent into reality represents the greatest challenge for corporate financial management in the years ahead. What needs to be done to accomplish this? The value pentagon-investment management, corporate governance, corporate restructuring, risk management, and performance measurement-presents a solution that involves leveraging each of the 5 factors.

Empirical evidence suggests that companies that perform well have organisational capabilities which enable them to exploit opportunities. What are these organisational capabilities? Carliss Y. Baldwin and Kim B. Clark mention 5 specific capabilities: external integration, or the ability of the firm to link its understanding of customers with engineering design to develop new products; internal integration, or the ability to perform efficiently; flexibility, or the ability to do a variety of things and to respond quickly to changes; the capacity to experiment and improve continually; and the capacity to cannibalise.

Since most of the outlays required to build capabilities are ordinarily not regarded as capital expenditure, investment in capabilities is usually done outside the financial system of resource allocation. However, this is not a satisfactory arrangement. The challenge for a company lies in developing a resource allocation system that accommodates investment in capabilities without sacrificing the benefits of formal financial analysis. Toward this end, the actions required are: identifying the capabilities that the firm should develop and ensuring that there is a firm organisational commitment to them; developing a capital budget for capabilities and a proper system of authorisation and accounting for expenditures relating to capabilities; translating the desired capabilities into appropriate goals; and linking the compensation of mangers to improvements in speed, quality, and flexibility.

Corporate restructuring has been the dominant global business theme since the 1980s. It has been fueled by a variety of forces like global competition, technological breakthroughs, managerial innovations, regulatory changes, transformation of formerly centrally-planned socialistic economies, and the expansion of international trade. Restructuring has proceeded mainly in 2 directions: it has put together focused global companies; and it has taken apart diversified conglomerates. Historically, corporate restructuring has been a reactive and episodic exercise. The future challenge lies in making it a proactive and continual exercise.

The performance measurement system of a firm has a strong bearing on the behaviour of its people. There is dissatisfaction with extant performance measurement systems across organisations. The common failings of performance measurement systems are: they are are out of sync with the strategy of the firm; there are too many of them; they contribute to lots of data floating around the system, but there is very little information; and their importance, especially in senior managerial levels, is exaggerated.

A major challenge to the CFO, who is the corporate scorekeeper, is to engineer an overhaul of the performance measurement system. The key steps in this process are: understand how the company's operational processes create benefits for customers; delineate strategies for delivering value to shareholders; develop measures for different levels of the organisation; carefully document the measures and test them; roll out the new measures; and link rewards to performance judged in terms of the measures finally adopted. The best corporate scorecards are the ones that balance leading and lagging indicators, internal and external perspectives, quantitative and qualitative factors, and financial and non- financial metrics.

Thanks to liberalisation and globalisation, business and financial risks have increased. Indian corporates now have to cope with heightened business risks arising from competition, technological changes, and shifts in consumer preferences. Further, they have to contend with greater volatility in interest rates, exchange rates, commodity prices, and stock prices.

Traditionally, most firms in India employed an ad-hoc approach to risk management and concentrated more on exposures emanating from specific transactions. A major challenge lies in developing an integrated approach to corporate risk management. In this endeavour, they should bear in mind several guidelines. One, hedge strategically. This calls for assessing the risk exposure of the firm's overall cash-flows, not just those of single transactions and using the risk-management tools deemed necessary to reduce the over-all risk exposure of the firm to a desired level. This is the level of risk at which the firm does not experience financial distress and has no problem in raising finances to support all value-adding investments. Two, employ a mix of real and financial methods. Real methods comprise business portfolio diversification, reduction in the degree of operating leverage, and joint ventures. Financial methods comprise forward and futures contracts, options, swaps, hybrid securities, insurance, and efforts to lower the debt-equity ratio.

And you must know the limits of financial methods. Financial methods cost less than the real methods, wherever there is a scope for substitution. The transaction costs may be high; credit risks may remain; and, in a financial crisis or in a volatile environment, the derivatives markets may not work in an orderly fashion.

To build a healthy long-term relationship with investors, it behoves every company to improve the standard of its corporate governance. Some of the measures to strengthen corporate governance are: regarding institutional investors as strategic partners, not adversaries; expanding the role of non-executive directors; separating the office of the chairman from that of the CEO; linking managerial compensation to performance and giving employees stock options; and improving corporate accounting and reporting practices.

Access to capital on economical terms is a major competitive weapon, and this can be ensured by improving the quality of corporate governance. Enlightened self-interest should prod a company to raise its standards of corporate governance. After all, as Gordon Donaldson put it, the price of independence is active self-discipline.

Prasanna Chandra is the Director of the Institute of Finance Management, Bangalore

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