Strategic Financial Managgement - Research Proposal Example

Strategic Financial Management This paper critically discusses the most vital aspect of strategic financial management i.e. risk assessment and management. The aim of this paper is to address the complexities and challenges faced by a company in the process of identification and assessing risks. The paper will try to point out the problems that are mostly generated from the different risk perceptions and how these risks can be evaluated effectively. The increasing importance of risk in corporate scenario is explained by putting forward a number of risk theories. This explanation will constitute the qualitative study of this report. Other than this also the report will include a mean by which risks can be quantified and the processes by which the companies make their investment decision. There are also current discussions which are being taken place in the corporate houses to adapt some model-based approaches for determining various risks. But controversies always remain while judging the importance of risks in any industry or sometimes in case of a particular company. According to some analysts risk assessment should be a more specific day to day activity catering to the daily operations. (Boyer, Garcia, 2007). Introduction: The Global recession which is affecting most of the industry sectors, is somehow forcing the companies to minutely asses the value addition capabilities of their functions and processes. (Coopers, Lybrand, 1905). This is a common scenario even when the company is not making losses. Strategic financial management of assessing risk of any investment cannot only be considered as a risk avoiding method, but also it can give competitive advantages when resources are optimally utilized. It is not a preventive measure; rather it is becoming a necessity for the companies to survive. Before making any investment on any project or up gradation of the current processes the company must make a correct assessment of the returns that is expected to be generated. This is a critical factor involving strategic financial management. The correct strategy for any corporate can be assessed by calculating the rate of return on the assets and equity the company is holding. It will signify how effectively the firm is utilizing the resources to maximize its wealth. A good financial management strategy always gets reflected in the company’s performance data. Most of the managers, in the international corporate believe the fact that volatility in the financial market is a permanent condition and it is going to remain throughout the course of operation of the company. (Coopers, Lybrand, 1905). The multinational corporations are always exposed to various categories of risks like effect of rise in energy costs and commodity costs etc, thus utilizing the resources optimally becomes more of a challenge. The process the companies mostly adapt to evaluate the proper return from an investment is called the cost benefit analysis. These are basis on which this particular research paper would be constructed. This paper critically aims at the most vital aspect of strategic financial management i.e. risk assessment and management. The aim of this paper is to address the complexities and challenges faced by a company in the process of identification and assessing risks. The paper will try to point out the problems that are mostly generated from the different risk perceptions and how these risks can be evaluated effectively. The increasing importance of risk in corporate scenario is explained by putting forward a number of risk theories. This explanation will constitute the qualitative study of this report. Other than this also the report will include a mean by which risks can be quantified and the processes by which the companies make their investment decision. There are also current discussions which are being taken place in the corporate houses to adapt some model-based approaches for determining various risks. But controversies always remain while judging the importance of risks in any industry or sometimes in case of a particular company. According to some analysts risk assessment should be a more specific day to day activity catering to the daily operations. (Boyer, Garcia, 2007). In this particular study the underlying thesis statement is the evaluation of the usefulness and effectiveness of risk management in strategic financial management. Thesis statement: The importance of risk management as a component of total strategic financial management. Objectives: In this particular report only risk management for any particular strategic investment made by a company is considered, so to evaluate the importance of it, three main clear stated objectives can be stated. Firstly, the report will evaluate why risk management is a necessity for any company in any given industry, and how the market volatility (can be quantified as risk) can affect any investment made by the firm. The second objective is to quantify risk and how firms can asses and determine the risks associated with a particular investment. A proper assessment is a crucial part of the total risk management system. The third and the last objective is to discuss the capital allocation models and how a firm will allocate its capital so that it attains a proper balance between risk and return. These three objectives will give a clear idea about the risk management system in different industries. Importance of Risk Evaluation in Strategic Financial Management: According to the prevailing concepts the main aim for any given firm is to maximize the profit and thereby maximizing the shareholder’s wealth. But with time with huge range of operations and investment options the concerned firm’s face huge lot of uncertainty in the market. In simple terms these uncertainties are called risks. There are few evident economic reasons for which a firm manager should consider risk as an important constraint while forecasting the profit of the firm. (Oldfield, Santomero, 1997, p. 7). The main rationale behind the risk assessment by any firm are the self-interest by the managers, the effects of the tax on the firm, the costs arising out of the financial distress and also sometimes due to the capital market structure the firm is operating with. (Oldfield, Santomero, 1997, p. 8). If each rationale is separately evaluated it can be inferred that in all of the cases the volatility of the market scenario will lead to the chances of lowering of profit for the firm. In case of the first rational it should be noted that managers have a limited ability to diversify their investments due to the limited wealth of the firms. According to the second rational the tax schedule and the tax burdens often decreases with the volatility in the income of the firm. This is also another important assessment that a firm should include in their strategic financial planning. The third and the fourth rational explain how the decline in the profitability of a firm determines the future course of action for the firm. Each of the reasons individually can be treated with great importance and also provides enough justification for any firm to adapt the risk evaluation techniques before taking any sort of investment decision. The next section will describe the various studies that had been conducted in the particular field. Literature review: This section will emphasize on the fact that why and how the risk assessment is so important for any kind of investment decisions. A look at the current studies made on this particular area will help in judging the advancements and the different fields this topic has catered to. The first study that will be discussed is a research conducted by Oldfield and Santomero. In their study they tried to find out the importance of risk management practices in financial institutions. The paper published in 1997 analyzed two issues, like it defines the roles played by the financial institutions in the overall financial sector and also side by side it also focuses on the role of the risk management in those particular types of firms which uses their financial informations to make their products (financial products). One of the most important objectives of this project was to explain the situations in which risks are absorbed by the firms and also how they transfer the risks into the consumers. The discussion also incorporates the consequences of absorbing the risk and how efficiently they are being managed. This area in particular contributes more to the actual research thesis. The second half of the analysis that is being discussed here studies the framework for risk management strategies catering to those risk elements which a firm chooses to eliminate from its balance sheet. The main aim here is to attain highest value addition from the current level of resources. The main function of the financial institutes is to provide market information to the market participants. While assessing the risk of the financial institute it should be considered that whether the firm is using its own resources for providing financial services or whether it is only working as an agent for the market participants. In both of the scenarios the risk assessment will change, as when the company is using its own resources for providing service it should balance its portfolio accordingly so that highest value is realized. For this a direct evaluation is been made of the types of procedures that are being followed in the risk management mechanism. The project ends by implementing specific principles for adapting firm wide risk management techniques. According to the report risk management should be an integral part of the organization and before taking any investment decision or implementing project plans it is necessary for the firm to have proper assessment of the potential threats and returns is made for that step that is going to be taken. In the next study, analysts Marcel & Martin Boyer and Rene Garcia tire to find out the importance of real and financial risk management in company’s view point. Here they have tried to concentrate on both the academic view of financial risks associated with a company as well as more practical view of including operational or real risks in their analysis. The study proposes t that both financial risk management and the operational management are necessary to actually enhance the value of the firm. According to the study when the financial markets are perfect a firm cannot increase its value by hedging risks. Hedging can only decrease the expected cost of financial downfall as it somewhat reduces the probability of the affect arising out of huge fluctuations in the markets. But when a project of a particular firm is considered both the risks have to be assessed in order to estimate the real risk associated with the expected cash flow levels and the report also captures the correlation between the cash flow and the risk factors faced by a firm. The operational management of the firm will aim at increasing the expected cash flow of the firm while the real risk management will aim at decreasing the risk factor. On the basis of the proper analysis of the risk and return parameters the efficient frontier of possible combination of cash flows and the expected risks is being developed. It has to be remembered that without the presence of market inefficiency, financial risks cannot play an important part in increasing the firm’s value. With the help of this efficient frontier the firm can evaluate the optimal return with the risk associated with it. The report gives a quantitative idea about how firms can asses and balance the strategic risks attached to any decision it takes. The next study which is going to be discussed concentrates on the role of risk management in the Corporate Finance decisions. The study is conducted by R.W.M. Johnson, and here the researcher find out the effect of the inclusion of certain risk parameters in the agricultural economy and how the certain approaches of proper risk assessments modifies the prevailing views on investment and financing along with the problems associated with the portfolio choice in this particular economy. The report gives a clearer view of the investment behavior of the firm. According to the author this corporate finance analysis gives a set of paradigms which explicitly explains the actual farm investment and portfolio related problems in more comprehensive way, than the other studies made in this field. Here in this study a non-corporate enterprise is being considered and in these cases unlike the corporate enterprises, the risk aversion to more financial exposure is the main factor influencing the optimum position of the farm firm. But according to another result derived from the study the value of the typical tax shelters affecting the optimum structure cannot be assessed correctly. In agricultural economy the assumptions like discount rates change the production valuations. For this particular economy the CAPM (Capital asset pricing model), provides much computational efficiency for the modeling of risk for the agricultural economy. Thus this study evaluates all the possible risk assessments models that are into practice, with respect to the agricultural sector and points out which tools helps in the proper evaluation of risks for the firm. Methodology: The basic objective of our study is to make a proper evaluation of the risk management as a subject and to find out how appropriate is it in the context of the strategic financial decision making. In the previous section of the proposal a fair bit of idea is being given about the essentiality of the subject and relevant discussion is being made about the various aspects related to financial risks. It is though clear that risk in a market is unavoidable and also it is inevitable. Now how a company is coping with the conditions and how well it is assessing the risk is up to the capability of a particular company. This report will serve only the purpose of a general guide which will help a firm to figure out different ways and means of evaluating risks and what measures they can take to successfully handle the given condition. It has to be remembered that the report does not focus on any particular industry segment, but it gives a more generalized view of risk management. The methodology caters to two main aspects. Firstly to know the importance of risk one has to have a clear idea about the way by which the risk elements are being calculated and how they are linked to its operational and financial activities. This first part is more analytical in nature. A comparative study can be made by taking one company from top five industry sectors and using appropriate tools for risk management, the risk assessing policies of those industries can be judged. This thorough calculation will give two straight results. Primarily it will decide on which risk assessment model is fit for which type of industry and also it will give results on what amount of risk factor that a company in a particular industry sector is exposed to. The second study that would be made is more theoretical in nature. When the first part of the assessment gives more of an insight about different risks that are associated with a particular firm, the second part will discuss about how to minimize the risks. It will discuss about the different capital allocation methods by the help of which risks could be avoided. This study is equally important as understanding the importance of risk management is not sufficient for any company, rather the usefulness of a proper risk management technique is also should be known. Allocation of capital is a strategic financial decision taken by a firm. Proper allocation often leads to the basis of a strong risk management policy. Capital allocation in other words means the way the firm uses its financial resources to find the optimum position balancing both risk and return. Assessment of risks: The first element of the risk that is required to assed is the stand-alone risk. This is a project specific risk. But in this particular study we will not include this specific risk because of the possibility of unavailability of data from the company balance sheet or other information of the financial statement. As most firms contain assets, a proper assessment can be made of how the addition of one project changes the total risk element of the portfolio. This will give a more complete assessment of the firm’s total risk element. Now the question arises on how the firm specific risks can be evaluated. It has to be kept in mind that the results calculated from the risk assessment are needed to be used for the capital budgeting decisions, which will discussed later. There are three statistical measures that would be used for the evaluation of the total risk of a company are range, standard deviation and the co-efficient of variation. The range gives a measure of how far apart the two extreme outcomes of a project are placed. (Peterson, Drake, Fabozzi, 2002, p.134). Higher the value of the range greater is the risk for that individual project. To get the adequate data the industry performance can be divided into three main economic divisions like boom, normal and recession and how these product or project cash flows varied in the different time horizons can be studied and on the basis of that the range can be calculated. After the calculation of the range, the standard deviation between the expected return and the range of the particular product is to be evaluated. (Peterson, Drake, Fabozzi, 2002, p.134). This will give an indication about the variability of the estimated project cost and the actual range of expected return. On the basis of these two, the co-efficient of variation is calculated; this co-efficient gives the final measure of how risky the particular investment was. (Peterson, Drake, Fabozzi, 2002, p.134). These evaluations and calculations will help the firm determining its future course of action. Considering the various aspects like economical condition, the industry rate of growth the firm can decide on the correct project to invest in. There are also other risk assessment methods, related to capital budgeting of the firms, which are not dealt with in this project. Allocation of capital: It should be remembered that the main aim of all these assessments and evaluation is to maximize profit of the shareholders at any given condition. This section of the project methodology will deal with the theoretical aspects about how a firm can deploy various strategies of allocating their capital, so that risk is minimized and optimum level of profit is obtained. To explain it more vividly a typical example of one specific sector namely the banking sector can be taken. The banks basically have two choices like they can increase the amount of return that can be earned from spending one unit of currency, or they can decrease the amount of expenditure required for per unit of currency to get the desired return. (Matten, 1999, p. 7). This gives the idea about the two ways the particular bank can utilize its resources; one capital allocation method focuses on maximizing return while the other focuses on minimizing risks. But it has also to be considered that most of the companies now a day does not necessarily go for only a straight forward strategy, but rather the companies focus on a more dynamic approach. The dynamic approach in brief is a cyclic process by which firstly the capital of the firm is determined and then the target of return that is expected is set. On the basis of the targeted return new capital is calculated and invested in the business and the final round provides an assessment about the success and failure of the fund allocation. (Matten, 1999, p. 8). All of these capital allocating techniques are being analyzed to get a proper understanding about the risk management techniques. Conclusion: The project here will give a thorough discussion about the two most important aspects of strategic financial managements namely, the risk management and the capital budgeting methods. This project points out how these two methods help a firm in attaining its main objective (maximizing returns) by avoiding uncertainties (minimizing risks). It has to be remembered that there other aspects of strategic financial management which are not being included in the study. After getting the results from this report, further study can be carried out in the fields like the Dividend Policy, Turnaround Strategies, Valuation etc. Including these studies will help in obtaining a more comprehensive study of the strategic financial decisions taken by the company. It should also be noted that the project will not give any idea about how an individual company can avoid risk and adapt strategies to which will help it serve the dual purpose of generating return and minimizing risk. This project only focuses on the importance and usefulness of the risk management techniques and what are the fundamental budget allocation methods that are being used in this regard. It stresses on the issue that what are the processes but does not suggest any particular method or tool for any sector or firm. Reference: 1. Coopers, Lybrand. (1905). Strategic Financial Risk Management: Orient Blackswan, India. 2. Peterson PP, Drake PP, Fabozzi FJ. (2002). Capital Budgeting: Theory and Practice: John Wiley and Sons, NJ. 3. Oldfield GS, Santomero AM. (1997). The Place of Risk Management in Financial Institutions: University Of Pennsylvania, USA 4. Boyer M, Boyer MM, Garcia R. (2005). The Value of Real and Financial Risk Management: CIRANO, Spain 5. Johnson RWM. (1992). Risk and the Farm Firm: A Corporate Finance View: Ministry of Agriculture and Fisheries, Wellington. 6. Matten C. (1999). Risk and Capital Management- An Overview: Australian Prudential Regulation Authority, Australia Read More