Decision-Making and Risk Management - Assignment Example

Assignment B Key Risk Management Decisions Institute Assignment B Introduction to Decision Making and Risk Management Decision-making is a cognitive process that results in selecting a belief or a course of action from different alternatives. Every decision produces a final choice that could trigger an immediate action or sometime in the future. It is a study to identify and choose alternative based on values and preferences of the decision-maker. Decision-making in management is essential, crucial and can be very critical under dire circumstances. Risk management is a broad area of the business universe. The decisions risk managers take are extremely important because good risk management could be the difference between a loss and a hefty profit. a) What are the key risk management decisions? When a business assigns an organization to develop risk management program (RMP) or independent risk management assessment when this business does not have relevant experience in managing risk, the resulting products will most probably be flawed. In this case the opportunity cost might be extremely large because of the lost time and the diminished goodwill of the company towards risk management (Conrow, 2003). Moreover, risk management is an ongoing process. The managers need to frequently alter the tools, the techniques, and their management in order to make the most of the available resources, to minimize loss. Effective risk management runs on the program team as well as outside help from subject matter experts. Risk management needs to be implemented at all levels of the organization: it should flow from top down from upper management to the bottom. The risk management process implemented on a particular program will undoubtedly be different when applied to a different scenario. Forcefully feeding the same process on a variety of different programs will lead to sub optimal results. An organization cannot implement the risk management framework effectively without incorporating sufficient resources such as including allocation of funds for personnel, training, testing, monitoring and the required tools (Gantz & Philpott, 2012). Establishing the capacity to identify and the capability, addressing such complex challenges and opportunities sits at the core of risk management (Homeland Security, 2011). The definition of risk management clears what the key management decisions are. The process of managing risks revolves around analyzing, identifying and communicating risk, avoiding, transferring or accepting or controlling risk to an acceptable level while weighing the cost against the benefits when making these decisions (Homeland Security, 2011). Developing alternatives to effectively manage risk is a crucial part of key risk management decisions. Risk management decisions do not always yield to the ideal outcome. The whole idea of managing risks is to minimize the effects of risk to the company. Good governance can sometimes lead to bad performance; however, bad performance does not mean that the governance was poor (Iverson, 2013). The justification for this claim is that risk management involves making decisions that will have an impact in the future, and luck plays a role in it. The primary decision for a risk manager is to determine the profitability of a project investment. Capital allocation and budgeting are the core activity in financial risk management of the company, and risk management is mandatory for healthy cash flows of the firm (Gupta, 2013). The perspective of the risk managers holds crucial importance. This perspective or angle determines the outcome of risk management. Ideally, the risk manager makes these decisions in the best interests of the shareholders. Maximizing the welfare of security holders is the core objective of the risk managers. b) What are the direct costs and benefits of these decisions and how might they be estimated? Direct costs of the project include its cost of capital, the cost of raising finance and the cost of raising equity. Estimation of these costs needs mathematical calculations to reach the Net Present Value (NPV). The NPV is a part of calculating the time value of money for evaluating an investment proposal (Hampton, 2011). The other popular method is determining the internal rate of return IRR. The flaw in IRR is it is a trial and error method (Hampton, 2011). The NPV method uses a required rate of return as the discount factor. In a few words, if the calculated NPV is positive it indicates that the project’s forecasted returns exceed its required return. This is one crucial indicator of to accept the proposal. On the contrary, if the NPV of a proposal is negative it means that its forecasted returns are less than the required rate of return. It is a strong indicator for risk managers to reject such a proposal. The IRR method is used in the industry for its unique benefits and differs from the NPV in that it assumes that the rate of return is the same rate for investing the future cash flows. The NPV method assumes that the future cash flows are invested at the required rate of return. Calculating the cost of capital (the direct cost) exposes the level of risk for a company (Crowther & Sefi, 2010). The lower the level of risk for a company or a project, the lower the cost of the capital. The cost of raising capital (borrowing) is lowered when the risk is low. This position is what every company seeks. Understanding the composition of the cost of capital is essential to understand the risk and eventually making risk managerial decisions. Moreover, this understanding also reveals the performance of the company. Two primary sources make up the cost of capital; cost of share and the cost of debt (Crowther & Sefi, 2010). The weighted average of these two factors gives the weighted average cost of capital of WACC. The actual calculation of WACC is more complex than just adding up these two elements. Risk managers spend considerable time in trying to calculate the most accurate weighted average cost of capital. The company’s strategic decisions mainly depend on calculating the NPV. Different costs of capital result in different NPVs. Hence, the accurate calculation of the cost of capital is necessary for making risk management decisions. Risk management and the decisions it demands are not unique to the investment world. Natural disinters and calamities also follow the same principles (excluding the financial tools) for managing risks. There are direct and indirect costs involved in managing this risk. Constructing houses in coastal areas requires disaster management skills to reduce the vulnerability of the new constructions (Stewart, Wang & Willgoose, 2014). The study conducted by Stewart, Wang & Willgoose (2014) analyzed the direct costs and benefits through NPV calculation. By increasing design wind loads for newly constructed houses in Brisbane and South East Queensland lead to net benefit (NPV in financial risk management terms at the discount rate of 4%, with 95% of direct and 5% of indirect benefits) was up to $10.5 billion by 2100 (Stewart, Wang & Willgoose, 2014). This is just an example of real life risk management decisions after analyzing the costs and benefits. c) What are the indirect costs and benefits and how might they be estimated? The indirect costs in risk management also form an essential part of the process, but it has secondary value to the cost of capital or direct cost. For instance, if a company decides to launch a new product, it might eat away the sales of pre-existing products of the company. For example, diet cola taking away the sales of regular coke. There is not a single example or strategy that explains the process of estimating indirect costs. In case a company decides to open a new department the direct and indirect costs to consider originate from program support and internal services IS (TBCS, 2014). The indirect costs usually refer to internal services (TBCS, 2014). The full cost of a project or investment is a subjective term because to calculate it the managers need to determine the complete scope of indirect costs. Some examples of indirect costs might be costs at regional and national headquarters, program support costs at regional and national level, etc. The indirect or secondary benefits and costs include by-products, spillovers, multipliers, and investment effects of the project or program (Cellini & Kee, 2010). For instance, the indirect benefit from space exploration is various spin-off technologies that benefit other industries (Cellini & Kee, 2010). Similarly, an example to show indirect costs might be of a dam built to benefit agriculture, but due to flooding it might ruin hiker’s path. After school activities in the school are also an indirect cost of something probably beneficial. Estimating indirect costs and benefits is a subjective matter and varies according to each project. There are directly calculable formulas available for calculating direct costs and even then it takes days to find an accurate number. Indirect costs are complex and require the subjectivity for reaching accurate results. To calculate overhead many businesses rely on standard indirect cost allocation number on top of their direct costs. Usually, they add somewhere from 30% to 60% of their direct on top of their direct costs in the name of indirect costs (Cellini, & Kee, 2010). They make it a subset of direct costs under heading such as personnel expenditures. The matter of estimating indirect cost this way is debatable and begs to answer the query whether a specific program really adds marginal cost to overhead agencies (Cellini, & Kee, 2010). As discussed earlier, indirect cost estimation is a subjective matter. A better alternative of calculating an estimated overhead, the evaluator must use activity based costing ABC (Cellini, & Kee, 2010). In this process, the overhead costs are assigned based on specific cost drivers. For instance, if a program is to use summer help in a college it will involve significant personnel actions and then additional costs will be allocated to the project under additional costs to personnel or human resource office (Cellini, & Kee, 2010). Even though it a better alternative for estimating indirect costs but it is not perfect. For instance, in case the government shifts costs to the private sector in regulatory activity, the ABC method can be helpful but it not a one-size-fits-all solution. Indirect costs to other economic sectors, social groups and participants are controversial and estimation of such costs can be problematic It is recommended that the evaluators should separate costs (and benefits) to different groups (Cellini, & Kee, 2010). So the allocation should be according to groups like costs to participants, costs to government, and cost to society. To lower indirect costs, a company needs to improve efficiency and effectiveness of operational risk and incident management processes. The key risk management decisions about investment also follow the same rules. To better estimate costs and manage risks, there are certain guidelines that help in getting the desired outcomes for risk managers. A company might invest in a project that might go to waste due to unforeseen circumstances. There is no question of bad judgment here. Example of this scenario can be natural disasters ruining the construction site or political unrest in the country of investment. The Fundamental Rules of Risk Management (2012) by Nigel Da Costa Lewis summarizes the key points of risk management decision making for good corporate governance; 1) Separating ownership and control. This separation determines the direction of the company regarding the control and objectivity. It also eliminates the conflict of interests. 2) Corporate governance is not merely a compliance issue; to create and sustain a competitive edge is the ultimate goal. 3) Risk management should sit at the core of corporate governance. The majority of company failures occur because higher management neglects or poorly judges risk management. 4) Risk management is more than just a technocratic compliance exercise. It is composed of concrete ideals and values, accountability and responsibility constitute the prime values. Corporate business and ethical values determine the risk managerial guidelines while respecting laws, internal regulations, and delegating authorities. And the results include improved corporate citizenship, transparency and strengthened trust. 5) Having a broad, well understood and widely accepted risk management process is synonymous with strong corporate governance. 6) Explicit commitment of senior management to good governance principles depends on market regulation and regulatory policing. 7) Despite effective risk management, future breakdowns in corporate governance results in financial distress to shareholders and stakeholders. This crisis is inevitable because cupidity and greed are inherent human characteristics. Regulatory and economic system of a country that lowers the cost of capital promotes good corporate governance and facilitates the operations of efficient capital markets. References 1. Conrow, E. H. 2003. Effective risk management: Some keys to success. AIAA Inc. 2. Cellini, S. R. & Kee, J. E. 2010. Cost effectiveness and cost benefit analysis. in Handbook of Practical Program Evaluation. [Available online] http://home.gwu.edu/~scellini/CelliniKee21.pdf [Accessed 29 November 2014] 3. Crowther, D. & Sefi, S. 2010. Corporate governance and risk management. Bookboon. 4. Costa, N. D. 2012. The Fundamental Rules of Risk Management. FL: CRC Press. 5. Gantz, S. D. & Philpott, D. R. 2012. FISMA and the risk management framework: The new practice of federal cyber. Newnes. 6. Gupta, A. 2013. Risk management and simulation. FL: CRC Press. 7. Hampton, J. J. 2011. The AMA Handbook of Financial Risk Management. NY: AMACOM Division American Management. 8. Homeland Security. 2011. Risk management fundamentals: Homeland security risk management doctrine. Department of Homeland Security. [Available online] https://www.dhs.gov/xlibrary/assets/rma-risk-management-fundamentals.pdf [Accessed 29 November 2014] 9. Iverson, D. 2013. Strategic management: A practical guide to portfolio risk management. John Wiley & Sons. 10. Stewart, M. G., Wang, X. & Willgoose, G. R. 2014. Direct and indirect cost-and-benefit assessment of climate adaptation strategies for housing for extreme wind events in Queensland. Nat. Hazard Rev. 15(4). [Available online] http://ascelibrary.org/doi/abs/10.1061/(ASCE)NH.1527-6996.0000136 [Accessed 29 November 2014] 11. TBCS. 2014. Guide to costing. Treasury Board of Canada Secretariat. [Available online] https://www.tbs-sct.gc.ca/pol/doc-eng.aspx?id=12251§ion=text [Accessed 29 November 2014] Read More