Question

How does risk affect a company's financial decisions? What risks should a CFO consider in making a decision? Name at least five and describe each.

Answer 1

How does risk affect a company's financial decisions? What risks should a CFO consider in making a decision? Name at least five and describe each.

Answer:

CFO ( Chief Financial Officer) makes many decision that can affect the company's performance profitably or may be in adverse. Risks are different and to name a few, there could be possibly Business risk(also known as Operating Risk), Investment Risk, risks involved in restructuring the Capital structure, risk in sharing the same views that of shareholders (Agency problem) etc.

In the question, we've been asked to understand what could be the company's financial decisions does a CFO makes and what are the risks involved in each, which we are going to elaborate on each by stating each company's financial decision as below:

1) Capital Allocation and Delegation - Risks to be considered by a CFO:

In order to maximize the company's revenues and operating efficiency , CFO makes a decision over reforming the structure of capital by allocating the sufficient capital either by issuing an equity or debt, or may raise the debt allocation par with equity, or could hedge the derivative stock to decrease the future market risk. . At times, pay back to the shareholder via dividends, and repay of debt is also considered as Capital allocation. More money contributes investing in Research or, announcing the dividend to the shareholders in order to raise the value to the company.

Risks that are to be considered by a CFO can be :

Raising the debt shouldn't raise the negative consequences or risk to the capital as interest charged can be in huge amounts to the company.

Indiscipline capital - allocation can always affect a company's performance and can lead to market risk and credit risk. Whereas both the shareholders and management has to suffer because of poorer decisions made by the CFO.

Selection of Right methods to invest in the external and internal sources, if not - may lead to a risk caused by external and internal vulnerabilities.

2. Investments to be made - Risks to be considered by a CFO:

Investments made could be from long to short in duration. CFO needs to understand the the economy, demand for the product and technology that's currently implemented in order to understand the Investments to be made to raise the money for smoother operations of the company. For an efficient management, CFO should ensure the company's liquidity for sufficient working capital, and understand the market in depth to make risk against the volatility of the stocks/bonds instruments.

Risks that can be considered by the CFO are market risk, reinvestment risk and also liquidity risk.

3.Dividend Policy - Risks to be considered by a CFO:

Company's earnings reported every quarter will be evident by the higher growth in revenue and it's product sales. By all means, stock prices rise and company declares dividend which is again a decision made by the CFO. While declaring CFO must make sure how much should be announced as keeping in mind that money can be reinvested back to the business or can be used for other business purpose. But also it's duty of the management to regard the shareholder's wealth maximization.

Risks encountered could possibly be if dividends promised are distributed in huge amounts, this may lead to the inefficiency of operations management, which may lead to the liquidity crisis or operations risk.

4.Asset Management - Risks to be considered by a CFO:

Company has to frequently keep a check on working capital requirements, assets whether managed efficiently or not, depreciation policies, current asset management and fixed asset management. Else , risks could evolve in the nature of liquidity, operational losses when failed in strategic implementation of asset management decisions.

5. Mergers and Acquisitions - Risks to be considered by a CFO:

When business needs to be expanded and such decision is taken by a CFO, a potential plan and a team is required to make a business valuation. Mergers and Acquisitions happen when the other firm is sound but may face a lesser equity capital or higher debt in the capital and the main company takes an advantage by buying the whole stake of it making it own. Taking over the ownership gives the power and authority to enhance the operations by using the current funds of the company, although all the take overs and acquisitions may not result the happy ending. Some may not yield expected earnings in the first few years, which may give company some loss. This can be the risk followed by the CFO if in case made an incorrect valuation of a firm and has acquired or tried to merge with another company with the main company.