SIX Major Decisions in Finance

1. Investment Decision
2. Financing Decision
3. Working Capital management Decision
4. Profit Distribution Decision
5. Financial Risk Management Decision
6. Mergers & Acquisition Decision

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 Financial Risk Management
Decision
 Financial Risk Management is the process
of identifying risks, analysing them and
making investment decisions based on
either accepting, or mitigating them.
These can be quantitative or qualitative risks,
and it is the job of a Finance manger to use
the available Financial instruments to hedge a
business against them

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 What is Risk

Risk exists if there is something you don’t want to

happen – having a chance to happen!!!

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 What is Risk –
Take 2

The probability that some event will cause an

undesirable outcome on the financial health of your
business and/or other business/family goals
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Components of Risk –
Undesirable Outcome
Put simply, the Undesirable
Outcome is what hurts!
-lower than expected production
- catastrophically lower production
Deni
ed - inability to meet cash flow
X - loss of income
- catastrophic loss of income
- loss of life
- loss of buildings & other resources
- loss of health
- inability to get a permit or loan
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Components of Risk –
Event (Cause/Source of Risk)
The Event is what caused the hurt:
-weather event
- injury/death of an employee
- neighbors action against you
- surplus production of milk
- widespread poor grain production
- low quality inputs
- disagreement
- downward slide in general economy
- and countless more!!!

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Risk Increases the
More You Don’t Know

All The Potential Outcomes

The Probability of Occurrence
Cost of a Undesirable Outcome

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 Said Another Way:
The more you do know and understand about

All The Potential Outcomes

The Probability of Each Outcome Occurring
Cost of Undesirable Outcomes

the better long term risk manager you will be.

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What is Risk Management?

Assuring An Outcome
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 Five Primary Means of
Risk Management
Reduce:
1. Diversify your investments
2. Set stop-loss order
3. Use hedging strategies
4. Maintain an emergency fund
5. Avoid taking on too much debt
6. Monitor your investments

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 Five Primary Means of
Risk Management
Transfer
Transfer the cost of an undesirable outcome to someone
else:
1.Insurance

2.Derivatives

3.Outsourcing

4.Asset securitization

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 Five Primary Means of
Risk Management
Avoid
Completely avoid potential events thus providing a zero
probability that they will occur
1. Diversify your investments
2. Avoid high-risk investments
3. Avoid debt
4. Build an emergency fund
5. Be cautious with new investments

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 Five Primary Means of
Risk Management
Loss control
1. Loss prevention refers to activities to reduce the frequency
of losses
2. Loss reduction refers to activities to reduce the severity of
losses

Do Nothing
Let the risk happen and be ready to bear the consequences.
1. Monitor your investments
2. Maintain an emergency fund

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So, I now know
What Risk Management is,
but How do I do it???

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How???
 Step 1: Be aware, identify the risks you face.
 Step 2: Evaluate:
 the likelihood that the risk will occur, and
 how bad the hurt will be if it does occur
 Step 3: Decide on how you will address the risk
 reduce, transfer, avoid, nothing, or some combination
 Step 4: Implement
 What is the most frustrating words used in management?? Answer:
“If I had only ……”
 Step 5: Control
 Monitor to assure that what you said you would do, you did, and that
you are getting what you want out of your your risk management
strategies.

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 Prioritizing Which Risks to
Address First
Act if cost Immediate
High
effective action
Probability of
Happening
No action Action
Low required required
Small Catastrophic
Potential Impact
Source: Dr. Geoff Benson, North Carolina State University

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 Risk Vs Loss Exposure
 Risk: Uncertainty concerning the occurrence of a loss
 Loss Exposure: Any situation or circumstance in which a loss is possible,
regardless of whether a loss occurs.

 Objective Risk vs. Subjective Risk

 Objective risk is defined as the relative variation of actual loss from expected
loss
 It can be statistically calculated using a measure of dispersion, such as the standard
deviation
 Subjective risk is defined as uncertainty based on a person’s mental condition
or state of mind
 Two persons in the same situation may have different perceptions of risk
 High subjective risk often results in conservative behavior
 Peril and Hazard
 A peril is defined as the cause of the loss
 In an auto accident, the collision is the peril
 A hazard is a condition that increases the chance of loss
 Physical hazards are physical conditions that increase the chance of loss
(icy roads, defective wiring)
 Moral hazard is dishonesty or character defects in an individual, that
increase the chance of loss (faking accidents, inflating claim amounts)
 Attitudinal Hazard (Morale Hazard) is carelessness or indifference to a loss,
which increases the frequency or severity of a loss (leaving keys in an
unlocked car)
 Legal Hazard refers to characteristics of the legal system or regulatory
environment that increase the chance of loss (large damage awards in
liability lawsuits)
 Classification of Risk
 Pure and Speculative Risk
 A pure risk is one in which there are only the possibilities of loss or no loss
(earthquake)
 A speculative risk is one in which both profit or loss are possible (gambling)
 Diversifiable Risk and Non-diversifiable Risk
 A diversifiable risk affects only individuals or small groups (car theft). It is
also called nonsystematic or particular risk.
 A nondiversifiable risk affects the entire economy or large numbers of
persons or groups within the economy (hurricane). It is also called
systematic risk or fundamental risk.
 Government assistance may be necessary to insure non-diversifiable risks.
Classification of Risk
 Enterprise risk encompasses all major risks faced by
a business firm, which include: pure risk, speculative
risk, strategic risk, operational risk, and financial risk
 Financial Risk refers to the uncertainty of loss because of
adverse changes in commodity prices, interest rates, foreign
exchange rates, and the value of money.
 Personal risks involve the possibility of a loss or
reduction in income, extra expenses or depletion of
financial assets:
 Premature death of family head
 Insufficient income during retirement
 Most workers are not saving enough for a comfortable
retirement
 Poor health (catastrophic medical bills and loss of earned
income)
 Involuntary unemployment
 Property risks involve the possibility of losses associated
with the destruction or theft of property:
 Physical damage to home and personal property from fire,
tornado, vandalism, or other causes
 Direct loss vs. indirect loss
 A direct loss is a financial loss that results from the physical damage,
destruction, or theft of the property, such as fire damage to a home
 An indirect loss results indirectly from the occurrence of a direct physical
damage or theft loss, such as the additional living expenses after a fire to
a home. These additional expenses would be a consequential loss.
 Commercial Risks
 Firms face a variety of pure risks that can have serious financial
consequences if a loss occurs:
 Property risks, such as damage to buildings, furniture and office
equipment
 Liability risks, such as suits for defective products, pollution of the
environment,
 Loss of business income, when the firm must shut down for some time
after a physical damage loss
Burden of Risk on Society
 The presence of risk results in three major
burdens on society:
 In the absence of insurance, individuals would
have to maintain large emergency funds
 The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods
and services
 Risk causes worry and fear
Merger and Acquisition
Decision
 A merger and acquisition (M&A) decision is a strategic decision
made by a company to either acquire another company or
merge with it in order to achieve specific business goals.
 In an acquisition, one company buys another company outright
and takes control of its operations, assets, and liabilities. In a
merger, two companies combine their operations to form a
single entity.
 M&A decisions are usually made to achieve certain strategic
goals such as expanding market share, diversifying products or
services, acquiring key talent, or gaining access to new
technologies or markets. These decisions can also be made to
increase shareholder value, improve operational efficiency, or
reduce competition
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 Three Major Goals of the
Corporate Firm

 Profit Maximization
 Wealth Maximization
 Preserve Stakeholders wealth