The Risk Factor behind the Strategy Formulation of the Firm - Essay Example

?Introduction Organizations work in an uncertain environment and as such risk is normal characteristic of doing business. Each organization attempts to balance its risk and return profile in order to remain in business and also generate the required level of returns according to its risk preferences. However, in order to achieve a balance between the risk and return profile of a firm, it is important that firm must develop and construct strategies which can allow it to generate the kind of value which can balance both the risk and return.( Arnold, 2007), Risk therefore can affect organizations in different manners and as such the overall development of the enterprise wide strategies, making of investment decisions, calculations of hurdle rates as well as the mergers and acquisitions decisions are almost all made based on the firm’s effort to balance its risk and return. It is however, critical to understand that such balancing act often depend upon the firm’s choice of the risk level which it attempts to undertake. (Walsh, 1996), As such the growing firms may be more risk loving and willing to take on higher level of risks and therefore all their decisions to expand and develop their markets will be based upon the higher degree of risk firm is willing to assume. Similarly, if a firm is more mature and risk averse in nature, its overall strategies will be relatively different as compared to a growing firm. (De Wit, & Meyer,1998). This paper will attempt to argue and explore that a firm’s overall risk consciousness governs the underlying strategies of the firm. The concept of Risk and firm The question of whether risk is the major factor behind the strategy formulation or not need to be discussed from the different perspectives. Each organization operates in an environment which is both internal and external to it and therefore develops its strategies in accordance with its environment. Firms, to a large extent, develop their capabilities to deal with the risks arising from their internal environment however; it’s the external competitive landscape of a firm which poses it significant and important risks because of the volatile and uncontrollable nature of the external environment. The overall development of the risk consciousness of the firm therefore largely depends upon the kind of external environment faced by the firm and how firm can actually utilize its strengths to withstands such external risks Risk as a concept therefore outlines that the outcome of any decisions or strategies of a firm may not be exactly according to what is perceived by the firm. As such it becomes critically important for the firms to account for and plan risks and develop strategies which can help them to counter risks arising from their internal as well as external environment. It is this uncertainty of the external environment which firms need to account for and prepare themselves through proper planning and strategy formulation process. It is also important to understand that the overall risk factors in an external environment can be diverse however; normally firms perform PESTLE Analysis to analyze their external environment. PESTLE Analysis allows the firms to actually evaluate the impact which political, economic, social, technological, legal and environmental factors could have on the firm. (Ellis, & Williams, 1993) If a firm has relatively high tolerance for the risk, it may choose to work in an environment which can be politically volatile and uncertain. For example, any firm willing to operate in Afghanistan now must have relatively higher tolerance for the risk because of volatile and extremely uncertain political environment. As such its policies and strategies will be driven by the volatility of the external environment within which it is operating or willing to operate. Risk and Return Risk and Return criteria serves as the basic premise under which all the economic decisions are made. Every investor as well as the firm attempts to decide and take actions based on their overall risk and return profile. The risk and return criteria suggests that the higher risk taking should be compensated with the higher returns and therefore any strategy, any action which cannot compensate an investor or a firm for assumed level of risk should not be undertaken. The decisions based on the risk and return criteria therefore are also made based on the mean and variance criteria and the assumed utility which any given action or activity can provide. (Copeland, Koller, & Murrin,1990) It’s significant to note that the decision making and strategy formulation process at an enterprise wide level is always undertaken with a view to increase value of the firm and hence value for the shareholders. Since the basic objective of a firm’s management is to create value for the shareholders by increasing the overall value of the firm therefore all the investment decisions which are made take into consideration their value adding proposition.( Grundy, Johnston, & Scholes,1998) It is also important to note that there always exists a perceptual difference between the risk perception of shareholders and the managers of the firm. This perceptual difference between the assumptions of risk therefore often results into what is called agency cost. This is due to the assumption that managers take actions and formulate strategies which are often in their own benefits rather than taking the decisions and forming the strategies which can increase the value for the shareholders. (Bender & Ward,2002), Risk Consciousness of a firm It’s critical to note that every firm follows a typical life cycle in which it passes through different phases and therefore its overall strategies change as the firm passes through from one stage to another. A typical firm passes through four different stages of introduction, growth, maturity and decline and the overall risk taking capabilities and strategies of the firm therefore change according to the stage of lifecycle in which the firm currently is. (Rutterford, 1998) It has been argued that the firm’s at the initial stages of their lifecycle i.e. introduction and growth tend to have different risk consciousness and preference as compared to the firms which are at their maturity level or at the decline. When the firms are in the introduction and growth stage, they tend to assume higher risks and all the strategies of the firm therefore are driven by the aggressive risk taking strategy of the firm. At this stage, firms often develop the acquisition and expansion strategies which can allow them to either penetrate into the existing market or develop new markets or take another course of action. (Neale, & Haslam, 1994) For example, a growing firm willing to further penetrate into an existing market may develop the strategy of introducing new products in the same market at relatively quicker pace. New and untested products often carry higher risk of failure however, despite higher risks of failure; firms undertake such strategies because of their willingness to further penetrate the market.( Grundy, 1995) It is therefore assumed that the firm’s overall risk consciousness change as the firm progresses through its lifecycle. The change in the risk consciousness therefore can change the strategies a firm can deploy in order to compete in the market. As discussed above that a growing firm may be willing to operate even in Afghanistan by assuming higher risk and as such crafting its strategies in a manner which can balance its risk and return profile in Afghanistan. The overall purpose of such market development strategy will therefore be driven by the objective of achieving higher returns at the cost of assuming more risk for operating in Afghanistan. It is therefore all depends upon the kind of environment a firm is facing and its overall stage in lifecycle which largely determines its overall risk consciousness and thus allow the firms to subsequently develop their strategies to match with its risk consciousness. (Johnson, & Scholes, 2008), Conclusion The basic objective of a firm’s management is to maximize the value of the firm and therefore create value for the shareholders. In the quest for creating more value, managers often have to take decisions which carry certain degree of risk however; this degree of risk depends upon different factors. Firms often face two types of environments i.e. external and internal and given the volatility and uncertainty of their environments, they design and implement their strategies. This element of uncertainty is often called risk therefore almost all the strategic decision making process is driven by this element of uncertainty. If the firm’s external environment is more volatile, it can provide a glimpse into the overall risk consciousness of a firm because working in a volatile environment entails that in order to survive, firm has to make strategies to withstand such volatile environment otherwise it will be out of the business. Secondly, a firm’s overall risk consciousness is also driven by its life cycle and therefore all its strategies are developed accordingly. Firms which are growing often develop and implement aggressive strategies through which they either tend to penetrate into the existing markets through fierce price cutting, introduction of new products or they enter into new markets and untested markets. On the other hand, firms at their maturity and decline stage may prefer to play safe and develop strategies which can only minimize their risks and allow them to survive at their existing growth rates. References 1. Arnold, G (2007), Essentials of Corporate Financial Management, Prentice Hall 2. Bender, R & Ward,K (2002), Corporate Financial Strategy 2nd edition, Butterworth Heinenann 3. Copeland, T, Koller, T & Murrin, J. (1990) Valuation: measuring and managing value, New York: John Wile 4. De Wit, B. and Meyer, R., (1998) Strategy: Process, Content, and Context. 2nd edition, London: International Thompson. 5. Ellis, J & Williams, D (1993) Corporate Strategy and Financial Analysis, 1st edition – Pitman Publishing 6. Grundy, T (1995) Breakthrough Strategies for Growth, 1st edition, FT Pitman Publishing 7. Grundy, T, Johnston, G & Scholes, K (1998) Exploring Strategic Financial Management 1st edition – Prentice Hall 8. Johnson, G & Scholes, K (2008), Exploring Corporate Strategy, 8th edt, Prentice Hall 9. Neale, A., and Haslam, C., (1994) Economics in a Business Context, London. Thomson Business Press 10. Rutterford, J (1998) Financial Strategy: Adding Shareholder Value. John Wiley & Sons 11. Walsh, G (1996), Key Management Ratios, Financial Times Read More