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 Katapatan Subd. Banaybanay, City of Cabuyao, Laguna

COURSE:FINANCIAL MANAGEMENT 2
Course Code: ACC 121A
Course Description: Conceptual Frameworks and Accounting Standards
Course: BS Accountancy

MODULE 1
Financial Risk Management

Risk management =the process of measuring or assessing risk and

developing strategies to manage it.
Is a systematic approach in identifying , analyzing and controlling areas or
events with a potential for causing unwanted change.
It is a act or practice of controlling risk .It includes ; risk planning ,assesing
risk,developing risk handling options,monitoring risk

BASIC PRINCIPLES OF RISK MANAGEMENT

Risk Management should :
1. Create Value- resource spent to mitigate risk should be less than the
consequence of inaction, i.e.,the benefits should exceed the costs.
2 .address uncertainty and assumptions
2. be an integral part of the organizational processes and decision-making
3. be dynamic, iterative, transparent, tailorable, and responsive to change
4. create capability of continual improvement and enhancement considering
the best available information and human factors
5. be systematic, structured and continually or periodically reassessed.

PROCRSS OF RISK MANAGEMENT

According to ISO 31000 “RISK MANAGEMENT-PRINCIPLES GUIDELINES ON
IMPLEMEMTATION “the process of risk management consist of several steps
as follows;
1.Establising the Context : this will involve
a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process
c. Maping out of the ff;
- the social scope of risk management
- the identity and objectives of the stakeholders
- the basis upon which risk will be evaluated,constraints
d. Defining a framework for the activity and a agenda for identification
e. Developing an analysis of risk involved in the process
f. Mitigation or a solution of risk using available technological,human
and organizational resources.

2. Identification of potential risk – can start with the analysis of the source
of problem or with the analysis of the problem itself. Common risk
identification methods are ;
a. Objective-based risk
B. Scenario based risk
c. Taxonomy based risk
d. Common risk checking
e. Risk charting

3. Risk Assessment

The Performance of Assessment methods should consist of the following elements:

1. Identification,characterization and assessment of threats

2. Assessment of vulnerability of critical assets to specific threats
3. Determination of the risk
 4. Identification of ways to reduce those risk
5. Prioritization of risk reduction measures based on a strategy

POTENTIAL RISK TREATMENTS

1.Risk avoidance

2.Risk reduction

3.Risk sharing

4.Risk retention

Risk avoidance -includes performing an activity that could carry a risk, like not
buying a property of business in order not to take a legal liability that comes with it.
But avoiding risk, however, also means losing out on the potential gain that
accepting the risk may have allowed. Not entering business to avoid the risk of loss
also avoids the possibility of earning profits.

Risk reduction- involves reducing the severity of the loss or the likelihood of the
loss from occurring

Risk sharing- means sharing the another party the burden of the loss or the
benefit of the gain from the risk and the measures to reduce a risk.

Risk retention- accepting the loss or the benefit of the gain from risk when it
occurs

AREAS OF RISK MANAGEMENT

The most commonly encountered areas of risk management includes

1.Enterprise risk management

2.Risk management activities as applied to project management

3.Risk management for megaprojects

4. Risk management of information technology

INVESTMENT RISK – Rational investors would agree that an investment’s required

return should increase as the risk of the investment increases.
BUSINESS RISK- Uncertainty about firm’s sales and operating expenses. Clearly
that firm’s sales are not guaranteed and will fluctuate if a the economy fluctuates or
the nature of the industry change

FINANCIAL RISK- firm’s capital structure or sources of financing determine financial

risk. If the firm is equity financed, the any variability in operating income is passed
directly to net income on an equal percentage basis. if the firm is partially financed
by debt that requires fixed interest payments or by preferred stock that requires
fixed preferred dividend payments, then these fixed charges introduces financial
leverage.

LIQUIDITY RISK- is associated with the uncertainty created by the inability to sell
the investment quickly for cash.

DEFAULT RISK-refers to the probability that some or all of the initial investment will
not be returned. The degree if default risk is closely related to the financial
condition of the company issuing the security and the security’s rank in claims on
asset in the event of default or bankruptcy. For example, if a bankruptcy occurs,
creditors including bondholders have a claim on assets prior to the claim of ordinary
equity shareholders.

INTEREST RATE RISK-because money has time value, fluctuations on the interest
rates will cause the value of an investments to fluctuate also. Movements in interest
rate affect almost all investment alternative. For example, a change in interest rate
will impact the discount rate used to estimate the present value of future cash
dividends from ordinary shares. This change will materially impact the analyst’s
estimate of the value of a share of ordinary shares.

MANAGEMENT RISK- decisions made by a firm’s management and board of

directors materially affect the risk faced by investors. Areas affected by these
decisions range from product innovation and production method (business risk and
financing (financial risk) to acquisition.

COMMONLY USED TECHNIQUES AND MODELS IN ASSESSING INVESTMENT

ALTERNATIVES

UNDER RISK OR UNCERTAINTY ;

1. Probability

2. Value of information

3. Sensitivity analysis

4. Simulation
5. Decision Tree

6. Standard deviation and coefficient of variation

7. Project beta

Probability

Decision making under certainty

Decision making under certainty means that for each action there is only one event and
therefore only a single outcome for each action. When an event is certain, there is a 100%
chance of occurrence, hence the probability is 1.0
Decision making under uncertainty which is more common in reality, involves several events fro
each action with its probability of occurrence. The decision makers may know the probability of
occurrence of each events because of mathematical proofs OR the compilation of historical
events.In the absence of mathematical proofs OR the compilation of historical events, he may
resort to the subjective assignment of probabilities.

ASSIGNING PROBABILITIES
Because decision makers niormally deal with uncertainty, rather than certainty, they must
estimate the probability of various outcome
Probability distribution – describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events. It can be based on the data if management
believes that the same forces will continue to operate in the future.
(a.) A probability of 0 means the event cannot occur, whereas a probability of 1 means
the event is certain to occur.
(b.) A probability between 0 and 1 indicates the likelihood of the event’s occurrence, e.g.,
the probability that a fair coin will yield heads is 0.5 on any single toss

Basic Terms Used with Probability

(1) Two events are mutually exclusive if they cannot occur simultaneously (e.g., heads and
tails cannot both occur on a single toss of a coin)
(2) The joint probability for two events is the probability that both will occur
(3) The conditional probability of two events is the probability that one will occur given that
the other has already occurred.
 (4) Two events are independent if the occurrence of one has no effect on the probability of
the other (e.g., rolling two dice)
(a) If one event has an effect on the other event, they are dependent
(b) Two events are independent if their joint probability equals the product of
their individual probabilities.
(c) Two events are independent if the conditional probability of each event
equals its unconditional probability

ILLUSTRATIVE CASE 21-1. Decision Making under Uncertainty

J & K Considering two new designs for their kitchen utensils. Product A and B. either can
produced using the present facilities. Each product requires an increase in annual fixed cost of
4M. The products have the same selling price of 1,000 pesos and the same variable cost per
unit 800 pesos .
After studying past experience with similar products, management has prepared the following
probability destribution :

Management would like to know ;

1. The break-even point for each product?
2. Which product should be chosen,assuming the objective is to maximize expected
operating Income ?

Solution :

A.Both products have same CM per unit of 200 (1,000-800) Break even will be computed as follows
 BEP = 4,000,000 / 200 = 20,0000 units

B. (B.1) determine expected demand for two products

(B2.) Compute the expected operating income of the two products.

Product B should be chosen because of the bigger expected operating income with product A.

PAYOFF (DECISION) TABLES

payoff (decision) tables are helpful tools for identifying the best solution given several decision
choices and future conditions that involve risk.
It presents the outcomes (payoffs) of specific decision when certain states of nature (events not
within the control of the decision maker) occur.

Example ; a dealer of luxury yachts may order 0,1 or 2 yachts. The cost of each excess yachts is
50,000 pesos and the gain for each yachts sold is 200,000. Payoff table as follows.
The probabilities of the season’s demands are

Pr Demand
0.10 0
0.50 1
0.40 2

The dealer may calculate the expected value of each decisions as follows

Order 0 Order 1 Order 2

0.1 x 0 0.1 x (50,000) 0.1 x (100,000)
0.5 x 0 0.5 x 200,000 0.5 x 150,000
0.4 x 0 0.4x 200,000 0.4 x 400,000
EV (0) = 0 EV (1) = 75,000 EV (2) = 225,000

Perfect information – is the knowledge that a future state of nature will occur with certainty,
i.e., being sure of what will happen occur in the future.
Expected value of perfect information (EVPI) the difference between the expected value
without perfect information and return if the best action is taken given perfect information
- It is also the amount that the company is willing to pay for the market analysts’ errorless
advice.Assuming the market analyst could indicate with certainty.Of course the perfect
information is not perfect in the sense of absolute predictions

The value of perfect information tell us the maximum amount it is worth paying for it. Of we
know in advance which one of the outcome occurs, then we choose the decision which will
lead to the maximum payoff. This does not mean we can control the choice of outcome.The
uncertainty about the future outcome from taking a decision can sometimes be reduced by
obtaining more information first about what is likely to happen. Information can be obtained
from various sources. such as the ff.
1 .Market research surveys
2. Other surveys or questionnaire
3.Conducting a pilot test
4.Building a prototype model

example : From above table (Yacht dealer) If the yatch dealer were able to poll all potential
customers and they truthfully stated whether they would purchase a yacht this year (i.e., of the
perfect information about this year's yacht sales could be purchased), what is the greatest
amount of money the dealer should lay for this information? What is EVPI?

If the dealer had perfect knowledge of demand, he would make the best decision for each
state of nature. The cost of the other decisions is the conditional cost of making other than the
best choice the cost maybe calculated by subtracting the expected value from the expected
value given perfect information. This difference measures how much better off the decision
maker would be with perfect information. From the payoff table on above table ( Yacht dealer)
we find the value of the best choice under each state of nature

PR state of nature best action best action expected value

payoff(peso) (Pr x Payoff)
.1 Demand = 0 Buy 0 0 0
.5 Demand = 1 Buy 1 200,000 100,000
.4 Demand = 2 Buy 2 400,000 160,000
260,000

The dealer expect to make 260,000 with perfect information about future demand and 225,000.
if the choice with the best expected value is made. The expected value of perfect information
(EVPI) is then

Expected value with perfect information. 260,000

Expected value of the best choice. (225,000)
EVPI. 35,000
The dealer will not pay more than 35,000 for information about future demand because it
would then be more profitable to make the expected valuw choice than to pay more
information

Illustrative Case 21.-2 Expected Value of Perfect Information

Adventure corp. has three investment opportunities, each one yielding profits depending on
the state of the market.The managing department has estimated that the probabilities of the
three states occurring are as follows,

State Probability
I .5
II .2
III .3

The payoff table showing the incremental profits with each project is as follows :

Market state In (P000’s)

I II III
Project 75 20 5
Project 45 80 55
Project 35 60 90

REQUIRED:

1.Which project should be undertaken? Ignore risk and use the decision rule that the project with the
highest EV of profits should be taken.
2. What would be the value of perfect information about the state of the market? Would it be worth
paying 15,000 pesos to obtain this information?

SOLUTION:

1.EV of the profit for each project

Analysis ; Project C should be undertaken (ignoring risk) because it has the highest EV of profits

2.With perfect information about the future state of the market the company would choose the most
profitable project for the market state which the perfect information predicts will occur.

I. If state I is forecast, project A would be chosen 75,000

II. If state II is forecast, project B would be chosen 80,000
III. If state III is forecast, project C would be chosen 90,000

EV of profits if Perfect Information is given

Analysis : Since the EV of profits without information is 56,500 pesos ( choosing Project C), the value of
the perfect information to the company is (80,500-56,500=24,000) and the cost of the information is
15,000. It would be worthwhile to obtain it.

Simulation - is a technique for experimenting with logical and mathematical models using a
computer. Despite the power of mathematics many problems cannot be solved by known
analytical methods because of the behavior of the variables and the complexity of their
interactions. e. g.,
a. Corporate planning models
b. Financial planning models
c. New product marketing models
d. Queuing system simulations
e Inventory control simulations

Five steps of simulation procedures

1. Define the objectives
2.Formulate the model
3. Validate the model
4.Design the experiment
5.Conduct the simulation-evaluation results.

Advantage and Limitations of simulation

The advantage of simulations are as follows :
a .Time can be compressed
b. Alternative policies can be explored
c. Comolex system can be analyze

Limitations of simulations are as follows:

a. Cost
b. Risk of error

Illustrative case 21-4 simulation technique

The financial controller of Minitions. Inc. has drawn the ff. projections with probability
distributions:
wages and probability raw material probability sales revenue probability
salaries in in (P000's) in (P000's)
(P000's)
10-12 0.3 6-8 .2 30-34 .1
12-14 0.5 8-10 .3 34-38 .3
14-16 0.2 10-12 .3 38-42 .4
12-14 .2 42-46 .6

You are required to simulate the cashflow projection and expected cash balance at the end of
the sixth month Use the ff. random numbers

Wages and salaries 2 7 9 2 9 8

(P000’s)
Raw materials (P000’s) 4 4 1 0 3 4
Sales revenue(P000’s 0 6 6 7 0 2
Fixed cost =
14,000/month

Solution :
(a) Simulation of Cash flow Allocation
Random Number Allocation

Wages and salaries Raw materials Values Revenue

Midpoint(P Cumula Rand Midpoint(P Cumula Rand Midpoint(P Cumula Rand
000’s) tive om 000’s) tive om 000’s) tive om
probabi numb probabi numb probabi numb
lity ers lity ers lity ers
11 .3 0-2 7 .2 0-1 32 .1 0
13 .8 3-7 9 .5 2-4 36 .4 1-3
15 1 8-9 11 .8 5-7 40 .8 4-7
13 1 8-9 44 1 8-9

(b) Expected Value method of Cash flow Projection

EV of salaries and wages = (11 * 0.3) +(13 *0.5)+(15*0.2) = 12,800
EV of raw materials =(7*0.2)+(9*0.3)+(11*0.3)+(13*0.2)=10,000
EV of Sales Revenue=(32*0.1)+(36*0.3)+(40*0.3)+(44*0.2)=34,800
Expected net cash inflow per month = 34,800-12,800-10,000-14,000=2,000
Expected cash balance after 6 months= 50,000+(2,000*6)= 62,000

From the above table, the estimated cash balance at the end of sixth month is 62,000