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Milestones in financial management -- II

Ram Kumar Kakanil

IN THE 1980s came junk bonds. These have a higher risk of default than investment grade securities. They came on the logic that they have a substantially higher rate of return than other bonds. If a large number of these are held, even though some defaul t, the overall rate of return may be higher than that gained with investment grade bonds. The economic effect of this growing source of funds is turning out to be beneficial, as ambitious and innovative projects, which would not have been funded earlier, are being undertaken.

ESOP: Employee stock ownership plans (ESOPs) were introduced to motivate employees, by giving them partial ownership of the firm and, thereby, mitigating agency problems. ESOPs tend to entrench incumbent managers and enhance employee incentives, linking them with the firm's performance.

Inefficient markets: While contemporary financial markets may be more utilitarian than those in the past, many research studies show major inefficiencies in the capital markets. Schiller and others found that stock prices appear too volatile and cannot b e explained by rational forces. The term `speculative bubbles' came up and it was explained that stock prices are affected by human psychology and market passions.

LBO: The belief that a firm's efficiency could be enhanced by innovative contracts led to the rise of leveraged-buyouts (LBOs), which made the economic interests of owners and managers more concentric. A carrot-and-stick approach also motivated managers. The stick was the pressure imposed by the need to service substantial amounts of debentures issued by the LBO in the acquisition of the businesses, and the carrot was that managers could increase the value of their substantial equity holdings by reducin g the debt burden.

1990s

Market value added (MVA): It is a measure of wealth creation. It was argued that to create greater shareholder wealth one has to aim at increasing the economic value of the firm.

Economic value added (EVA): It is the gain (or loss) that remains after levying a charge against after-tax operating profits for the opportunity cost of all capital used to produce those profits. EVA is linked most directly, both theoretically and empiri cally, to MVA. Companies reap the full benefits of EVA when they use it as the centerpiece of their financial management system.

Reputation theory: The idea is that a firm/manager might care about its/his reputation for quality, skill, or some other attribute. This will reduce the agency problems between owners-managers and also affect the way a firm accesses the capital markets o r chooses its investment projects.

Financial engineering: This involves the use of derivatives to manage risk and create customised financial instruments. Financial engineers follow through the process of identifying the sources of risk, evaluating the strategic advantage of bearing risk, creating financial instruments to transfer risk, and using financial markets to value and shed risk. It can help in advancing a company's strategic goals.

Activity-based costing (ABC): It is a concept in which processes are mapped, bottlenecks identified, non-value-added activities highlighted and the cost drivers used to set the stretch targets. ABC gives managers the tools to identify cross-functional is sues and tackle them, both within and outside the firm.

Strategic cost management (SCM): It is the application of cost management techniques so that they simultaneously improve the strategic position of a firm and reduce costs.

Balanced scorecard: This provides a framework for identifying the operational factors that are behind the future success of an organisation. The firm, in its scorecard, reports a matrix of key success drivers for the businesses. It discloses both financi al and non-financial measurements such as customer loyalty, quality, revenue, and employee knowledge. An accurate view of these factors enables management to measure overall performance rather than merely look at short-term, bottom-line results.

These ideas and changes in the structure of the financial system came about because of a wide array of newly-designed securities and the increasing size and scale of business operations. The advances in computer and telecommunication technology, as also in the theories of finance, have made possible the implementation of large-volume trading strategies in securities.

(Concluded)

The first part of this article appeared on June 18.