Strategic financial management risk assessment decisions - Essay Example

Strategic financial management – risk assessment decisions The paper takes into consideration strategic financial management, which constitutes of risk assessment and management. Identification and assessment of risk is a vital component of decision-making for a company. The paper highlights certain troubles caused by the variation in perceptions of risk by different corporate houses. The importance of risk assessment is evaluated through a qualitative research, by putting forward some risk theories. Quantitative approach is also undertaken as the risks are quantified. The recent discussions about adopting model-based approaches to determine risks have been presented. However the controversies arise in this context especially when risk is supposed to be assessed. Certain analysts perceive that risk needs to be evaluated on a day-to-day basis based on the daily operations. The aim here is to address the importance of risk assessment in strategic financial management and mainly answer the question “how the firms assess their risk in order to attain optimal capital allocation?”. Background The recent global recession gives a reason to the industries to evaluate the risks involved in any kind of investment. Even when the company is not making losses, assessment of its value addition abilities is important. It also helps in understanding the company’s competitive advantages by optimizing the resources. Assessment of risk is a method of avoiding risk. Not only a preventive measure, risk assessment is a way of survival for the companies. Before any investment proper assessment of the returns of flow of returns over an estimated time period is to be calculated. The appropriate strategy for the companies is to calculate the rate of return on its assets and equity held by the company. a suitable financial management strategy also finds its place in the performance data of the firm. The multi-national firms are always exposed to different kinds of risks including increase in energy and commodity costs. For these firms utilizing resources optimally becomes a challenge at every moment. Aim and objectives The paper aims at addressing the different complexities and challenges faced by different firms in the process of risk assessment and how they take their daily decisions based on this. The following objectives need to be addressed: 1. To evaluate why risk management is a necessity for any company in any given industry. (Through the literature review/ qualitative survey) 2. To observe how the market volatility (can be quantified as risk) can affect any investment made by the firm. (Quantitative method) 3. To estimate how firms can assess and determine the risks associated with a particular investment. (Quantitative approach) 4. 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. (Qualitative method) Literature review A study by Oldfield and Santomero (1997) their work towards evaluation of risk management practices in financial institutions. The study on one hand focuses on the roles of financial institutions in the financial industry and also emphasizes upon the part played by risk management in the firms, which uses the financial information for their financial products. The study aimed at analyzing how these firms absorb the risks and how these are even transferred to the consumers. A part of the study also emphasizes upon the risk management strategies which address the elements of risk in the balance sheet and those the firms prefer to eliminate from there. 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. Johnson (1992) carried out his study to trace the effect of the inclusion of certain risk parameters in the agricultural economy and how 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. Boyer, Boyer and Garcia (2005) traced the significance of financial risk management from firm’s point of view. Both financial risk management and operational management are essential to enhance a firm’s value. When the financial market is working according to expectation, hedging of risk cannot increase a firm’s value. Hedging works when there are big fluctuations in the market. The risk associated with expected cash flows by evaluating the correlation between cash flow and risk factors encountered with a firm. 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 evaluate and balance the strategic risks attached to any decision it takes. Methodology: There are two main components in the methodology. In order to understand the significance of risk the calculation of risk elements is very important. The first part is qualitative and quantitative in nature where a comparison between different companies are undertaken on the basis of their operational and financial activities and their risk assessment policies. Essentially this 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 results obtained from risk assessment will help in the decisions of capital budgeting. The three statistical measures, which help in proper evaluation of the company’s risk, 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 sufficient information the industry performance can be separated into three main economic stages like boom, normal and recession and how these product or project cash flows varied in the different time horizons can be studied. On this basis, the range can be calculated. After the computation of the range, the standard deviation between the expected return and the range of the particular product is to be assessed. (Peterson, Drake, Fabozzi, 2002, p.134). This will indicate about the variability of the estimated project cost and the definite range of expected return. The co-efficient of variation is calculated on this basis. This co-efficient gives the final measure of how risky the particular investment is. (Peterson, Drake, Fabozzi, 2002, p.134). The second part is qualitative in nature. The paper will hence undertake the banking sector (a particular sector is chosen to analyze conveniently) in order to understand how the risk assessment is utilized for capital allocation. A dynamic approach is undertaken for this purpose. 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 these capital-allocating techniques are being analyzed to get a proper understanding about the risk management techniques. The study will only give a basic understanding of a firm’s way of risk assessment and capital allocation. The main limitation is the choice of one industry because our aim is not to compare between industries. This might as well be a further scope of our research where a cross sectional comparison might be carried out. GANTT CHART Week 1 week 2 week 3 Secondary research **** Draft ***** Final ***** References 1. Coopers, Lybrand. (1905). 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