FINANCIAL MANAGEMENT PART 2 PREPARED BY: ROMNICK E.

BONTIGAO, CPA

Chapter 21 Financial Risk Management

Risk Management
a. act or practice or technique of controlling
risk
b. process of measuring or assessing risk and developing strategies to manage it.
1. Risk Identification - Identification of risk and analysis of the course of
problem
2. Risk Assessment - Evaluating the potential severity of impact and the probablity of occurrence
and
prioritization of risk reduction measures based on
strategy
3. Risk management - risk handling options (systematically managed to reduce risk to an acceptable
level)
Application of potential risk
treatments*
4. Risk Monitor and Control - to determine how risks have changed and
controlling it
5. Documentation of overall risk mgt. program

Risk management is the identification, assessment, and systematically manage the risk to reduce the it
Key: to an
acceptable level.

Causes of Risk
a. uncertainty in financial market
b. project failures
c. legal liabilities
d. credit risks
e. accidents
f. natural causes
g. disasters
Basic Principles of Risk Mgt. (per ISO 31000)
Risk mgt should:
1. create value - benefits of risk mgt should exceed the costs
2. address uncertainty and assumptions
3. be an integral part of the organizational processes and decision-
making
4. be dynamic, iterative, transparent, tailorable, and responsive to
change
5. create capability of continual improvement
6. be systematic, structured and continually or periodically reassessed

*Potential Risk Treatments (Risk Management Techniques)

1. Risk Avoidance - Not entering a business to avoid risk of loss, but avoids also possibility of
earning profits
2. Risk Reduction or optimization - reducing the severity of the loss or the likelihood of the loss from
occurring
ex. Outsourcing
3. Risk Sharing - sharing with another party the burden of loss or the benefit of gain, from a risk, and the
measures to
reduce a risk
4. Risk Retention - involves accepting the loss or benefit of gain, from a risk when it occurs. Ex. Self
insurance
All risks that are not avoided are transferred or retained by default.

Areas of Risk Management - FM2 concerns to mgt of risks associated with the long-term investment in
equity shares,
bonds, and property and equipment (Investment Risks)

Factors considering the Investment Risks

1. Business Risks - refers to the uncertainty about the rate of return caused by the nature of the
business.
ex. Uncertainty about the firm's sales and operating expenses
Sales - fluctuate as the economy fluctuates or the nature of the industry
 changes
OE - if OE is variable - directly related to the production, if fixed, dictates the
operating leverage
2. Financial Risk - depending to the capital structure or source of
financing
Higher Debt ratio = Higher the interest expense, higher the risk
3. Liquidity Risk - uncertainty created by the inability to sell the investment
quickly for cash.
Selling of:
a. Capital asset (ex. Land, PPE, etc) = high risk
b. Cash equivalents, ST invest (Treasury Bills) = lower
risk
c. Equity share = high risk if there is a thin market.
where; thin market - when there are relatively few demandable shares and
investor
trading interest is limited. Resulting effect = Buyers are the
bosses.
4. Default Risk - the probability that some or all of the initial investment will not
be returned
ex. Claims against bankruptcy
5. Interest Rate Risk - the risk resulting from the fluctuation of interest associated with
investment.
ex. Change in interest rate will affect discount rate
Interest Rate - the price a borrower pays to use someone else's
money
Discount rate - the rate you use when adjusting for the time value
of money
ex. Determine the present value using the discount rate. At 10% DR, P90.91
investment
today will be P100 a year from now

6. Management risk - risk as a result of decisions made by a firm's management and BOD
7. Purchasing Power Risk - As a result of Inflation and Deflation
 Inflation - decrease purchasing power, and increases investor risks
Deflation - increase purchasing power, and decreases investor risks

Techniques and Models in Assessing Investment Alternatives under Risk or Uncertainty

1. Probability
a. Decision making under certainty - for each decision action there is only one event and therefore
only a single
outcome for each action. Certain - 100% occurrence
Example: Conversion of solid to liquid
b. Decision making under uncertainty - involves several events for each action with its probability
of occurrence
Assigning Probabilities
0 = event cannot occur
1 = certain to
occur
0 - 1 = likelihood of the event's
occurrence

Pay-off (Decision) Table - tools for identifying the best solution given for several choices and
future
conditions that involve risk
SON (State of Nature) - conditions affecting the alternative courses of actions
ACA (Alterantive courses of Actions) - the list of alternatives to
do

ACA Investment
(columns) alternatives
Profit per Inventory Quantity
(row) SON per Probability alternative Stocking
Projects
Poor Alternatives
Moderate
High
Illustration:
A dealer in luxury yachts may order 0,1, or 2 yachts for this season's inventory. The cost of carrying
each excess yacht is P50,000, and the gain for each yacht sold is P200,000. The sale of yacht per
probability is illustrated as follows:
Profit per Alternatives
SON and Probability Stock 0 Stock 1 Stock 2
Sale of 0 0.1 0 -50000 -100000
Sale of 1 0.5 0 200000 150000
Sale of 2 0.4 0 200000 400000

Required:
A. If you are the dealer of the yacht, how many stocks of yacht you shall put into inventory this
season?
(Assuming you will not rely on the professional to acquire errorless
advice).
B. In hiring professional advice, how much is the maximum fee you will pay to acquire his/her
service?

Solution:

A. Getting the best alternative without relying to professional or without perfect

information
1. Get the Expected value of the best choice, other term is EV without PI (EVPI-WO)
EVPI-WO = Best Choice = Highest EV

Compute each SON per probability according to the Alternative courses of

Actions
Formula:
EV = Probability Ratio x Note: Tabulate per Alternatives (column) then
Profit categorize per
SON and probability (row)

Profit per Alternatives

Stocking 0 Stocking 1 Stocking 2
 SON and Probability Profit EV Profit EV Profit EV
Sale of
0 0.1 0 0 -50,000 -5,000 -100,000 -10,000
Sale of
1 0.5 0 0 200,000 100,000 150,000 75,000
Sale of
2 0.4 0 0 200,000 80,000 400,000 160,000
EV 0 175,000 225,000
EVPI-WO = P225,000

B. Getting the maximum expense of acquiring erroless advice

1. Get the Expected Value with Perfect Information (EVPI-W)
Perfect Information - knowledge that a future state of nature will occur with
certainty
Select the highest EV per SON per probability (refer to your tabulation) then
sum-up.

Formula:
EVPI-W = Summation of Highest EV per probability per SON

Profit per Alternatives

Stocking 0 Stocking 1 Stocking 2
SON and Probability Profit EV Profit EV Profit EV
Sale of
0 0.1 0 0 -50,000 -5,000 -100,000 -10,000
Sale of
1 0.5 0 0 200,000 100,000 150,000 75,000
Sale of
2 0.4 0 0 200,000 80,000 400,000 160,000
EV 0 175,000 225,000

EVPI-W = 0 + 100000 + 160000 = P260,000

 Then:
2. Get the Expected Value of Perfect Information (EVPI-O)
EVPI-O = EVPI-WO less EVPI-W

EVPI - W = 260,000
Less: EVPI-WO 225,000
EVPI-O 35,000 The amount the company is willing to pay for the market
analysts' errorless advice. The value of Perfect
Information tells us the maximum amount it is worth paying
for it.
COI (Cost of Information) -
the
cost of acquiring perfect information.
Examples: Decision:
a. Market research surveys If EPVI-O > COI Accept/Conduct market study
b. Other surveys or questionnaire otherwise, do not accept it
c. Conducting a pilot test,
and Cost-Benefit Concept
d. building a prototype model

Other illustration:
JohnJames Corporation has three investment opportunities, each one yielding different profits
depending on the conditions of the market. The managing director has estimated that the probabilities
of the three investments occuring are as follows:
Conditions Probability
Poor 0.5
Moderate 0.2
High 0.3

The payoff table showing the incremental profits with each investment is as
follows:
Market Condition/ Poor Moderate High
Investment
A 75,000 20,000 5,000
 B 45,000 80,000 55,000
C 35,000 60,000 90,000

Requirement:
1. Which investment should be undertaken assuming the expected value is without perfect
information?
2. What would be the expected value of perfect information regarding the investments?
3. Would it be worth paying P15,000 to obtain this
information?

Solution:

2. Value of Information - Discussion of EVPI

3. Sensitivity Analysis - describes the effect of changes in prices, cost and cost drivers through
mathematical model.
This analysis requires the knowledge of cost behavior best illustrated through the help of
Contribution Margin
Income Statement Approach.

CMIS (Contribution Margin Income Statement)

An Income Statement presentation where the expenses are categorized and separated into Variable and
Fixed Cost. The difference of Sales and Variable Cost is called Contribution Margin.
Components
Abbre. Example: Solution
Cost Driver - level of
Activity CD 1000units 1,000 units
(Ex. Production Qty) Formula Ratio
Sales S CD x SPU SR SPU=P10 10,000
Less: Variable Cost VC CD x VCU VCR VCU=P 6 6,000
Contribution Margin CM CD x CMU CMR 4,000
Less: Fixed Cost FC CD x FCU FC=P3000 3,000
Net Income Before Tax NIBT 1,000
 CMIS Rules:
All costs are classified as either Variable and Fixed
1. Cost.
2. Cost and revenue relationships are predictable and linear over a relevant range of activity
and a specified period of time
3. Porduction equal Sales
4. When the Cost Driver Changes on a relevant range:
a. Total VC Varies directly with CD
b. VCU Constant
c. Total FC Constant
d. FCU Varies inversely with CD

Illustration:
JD Company has the following financial information for the current year
operations:
Sales (2500units @ P40) 100,000
VC 70,000
FC 20,000
Required:
1. Compute the net income before tax using CMIS approach.

2. Make a sensitivity analysis based on the following independent assumption:

a. If selling price is reduced by 10%, how much will be
the NIBT?
b. If the activity is increased by 500units, compute for
the NIBT.
c. If FC increased to P22,000, how much will be the NIBT?
d. If VCU and FC is reduced by 10%, how much will be the
NIBT?
e. Based on your answer on letter (a) and (d), what would be your conclusion?

4. Simulation - is a technique for experimenting with logical and mathematical models using a
computer
 Experimentation is organized trial and error using a model of the real world to obtain
information prior
to full implementation.

Advantages
1. Time can be compressed
2. Alternative policies can be explored
3. Complex systems can be analyzed
Disadvantages
a. Cost
b. Risk of error

5. Decision Tree - analytical tool used in a problem in which a series of decision has to be made at
various time
intervals, with each decision influenced by the information that is available at the time
it is made
shows the several decisions or acts and the possible consequences called events of each
act.

elements:
Decision node
State of nature

EV Expected Value (Pay-off)

Probablity

Illustration:
Let us say you can choose between two projects: A candy shop or lemonade stand. A candy shop can
earn up to P100,000, and a lemonade stand can earn up to P90,000. However, putting the candy shop
has
a 50% chance of success, which will you give you P100,000. However, if you fail, it will give you
P30,000 loss.
On the other hand, putting lemonade stand has also 50% chance of success and you can earn up to
P90,000,
 but if you fail, you will incur P10,000 loss. Which project would you choose? Illustrate using
Decision Tree
Analysis.

6. Standard Deviation and Coefficient of Variation - Chapter 26

7. Project Beta - Chapter 27