They must look at the complete picture of how to ensure survival in a competitive and technologically innovative world. The following is a brief examination of the risk factors that contributed to the near-bankrupt condition of the U. Had risk management been a top priority for the automobile companies, perhaps they would face a different attitude as they approach U.
ERM needs to be part of the mind-set of every company stakeholder. When one arm of the company is pulling for its own gains without consideration of the total value it delivers to stakeholders, the result, no doubt, will be disastrous. The players need to dance together under the paradigm that every action might have the potential to lead to catastrophic results. The risk of each action needs to be clear, and assuredness for risk mitigation is a must.
While Chapter 4 "Evolving Risk Management: Fundamental Tools" enumerated all risks, we emphasized the loss part more acutely, since avoiding losses represents the essence of risk management. But, with the advent of ERM, the risks that represent opportunities for gain are clearly just as important.
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We operate on the negative and positive sides of the ERM map and we look into opportunity risks. We introduce more sophisticated tools to ensure that you are equipped to work with all elements of risk management for firms to sustain themselves. Figure 5. Let us emphasize that, in light of the financial crisis of —, ERM is a needed mind-set for all disciplines. The tools are just what ERM-oriented managers can pull out of their tool kits.
For example, we provide an example for the life insurance industry as a key to understanding the links. We provide a more complete picture of ERM in Figure 5.
Source: Etti G. Baranoff and Thomas W.
As you saw in Chapter 4 "Evolving Risk Management: Fundamental Tools" , risk management functions represent an integrated function within the organization. In Figure 4. While the enterprise risk management ERM function compiles the information, every function should identify risks and examine risk management tools. Finance departments may take the lead, but engineering, legal, product development, and asset management teams also have input.
Even nonpublicly traded firms share the same goal. Instead of the simple stock value, nonpublic firms may well create value using inputs such as revenues, costs, or sources of financing debt of equity. In and , even strong companies felt the effects from the credit crisis.
Textron and other well-run companies saw their values plummet. The inputs for a model that determines value allow us to examine how each input functions in the context of all the other variables.
See references to Capital versus Risks studies such as Etti G. Baranoff, Tom W. This approach replaces the traditional concept of profits maximization, or expected profit maximization, enabling us to introduce risky elements and statistical models into the decision-making process. Actual market value should reflect all these elements and includes all the information available to the market.
This is the efficient-markets hypothesis. Recently, many developed countries have seen a tendency to change the rules of corporate governance. Traditionally, many people believed that a firm should serve only its shareholders. However, most people now believe that firms must satisfy the needs of all the stakeholders—including employees and their families, the public at large, customers, creditors, the government, and others.
In some countries, corporate laws have changed to include these goals. It reflects positive corporate responsibility image. Another significant change in a way that firms are valued is the special attention that many are giving to general environmental considerations. A case in point is the issue of fuel and energy. Fuel cost contributed in large part to the trouble that the U. With the U.
Further, the government made it clear that Detroit must produce competitive products already offered by the other large automakers such as Toyota and Honda which offered both its Accord and its Civic in hybrid form. Chevrolet will offer a plug-in car called the Volt in the spring of with a range of more than 80 mpg on a single charge. Chrysler and Ford plan to follow with their own hybrids by World population growth and fast growth among emerging economies have led us to believer that our environment has suffered immense and irrevocable damage.
Its resources have been depleted; its atmosphere, land, and water quickly polluted; and its water, forests, and energy sources destroyed. From a risk management point of view, these risks can destroy our universe, so their management is essential to sustainability The capacity to maintain a certain process or state. Sustainability, in a broad sense, is the capacity to maintain a certain process or state. It is now most frequently used in connection with biological and human systems. In an ecological context, sustainability can be defined as the ability of an ecosystem to maintain ecological processes and functions.
Some risk management textbooks regard the risk management for sustainability as the first priority, since doing business is irrelevant if we are destroying our planet and undoing all the man-made achievements. To reflect these considerations in practical decision making, we have to further adjust the definition and measurement of business goals. To be sensible, the firm must add a long-term perspective to its goals to include sustainable value maximization.
Assume that we base firm valuation on its forecasted future annual cash flow.
Assume further that the annual cash flow stays roughly at the same level over time. We know that the annual cash flows are subject to fluctuations due to uncertainties and technological innovations, changing demand, and so forth. Capital budgeting is a major topic in financial management. The present value of a stream of projected income is compared to the initial outlay in order to make the decision whether to undertake the project.
For more methods, the student is invited to examine financial management textbooks. Table 5. We assume that the value of the firm is ten times the value of the profit, This assumes an interest rate for the cash flow of 10 percent. The value of the firm is the value of the perpetuity at 10 percent which yields a factor of ten.
See the famous Miller-Modigliani theorems in the financial literature of and However, this analysis ignores some effects and, therefore, leads to incorrect conclusions. In reality, the risk manager takes an action that may improve the state of the firm in many directions. Recall our demonstration of the safety belts example that we introduced Chapter 4 "Evolving Risk Management: Fundamental Tools". Customers may increase their purchases from this firm, based on their desire to trade with a more secure company, as its chances of surviving sudden difficulties improve.
Many also believe that, as the firm gains relief from its fears of risks, the company can improve long-term and continuous service. Employees would feel better working for a more secure company and could be willing to settle for lower salaries. In addition, bondholders creditors will profit from increased security measures and thus would demand lower interest rates on the loans they provide this is the main effect of a high credit rating.
Thus, risk management activity may affect a variety of parameters and change the expected profit or cash flow in a more complex way. We present the state of this hypothetical firm as follows:. The profit or expected profit of the company has risen.