Risk management and shareholders wealth Updated: Oct 31 As conducting business itself becomes increasingly complex, managing these risks and dealing with them adequately as and when they arise becomes vital.
Firstly, the wealth maximization is based on cash flows and not profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits. Secondly, profit maximization presents a shorter term view as compared to wealth maximization.
Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business. Thirdly, wealth maximization considers the time value of money.
It is important as we all know that a dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. Fourthly, the wealth-maximization criterion considers the risk and uncertainty factor while considering the discounting rate.
The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.
Positive and higher EVA would increase the wealth of the shareholders and thereby create value. In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders to achieve their objectives and therefore is superior to profit maximization.
For financial managers, it is a decision criterion being used for all the decisions. For more clarity, refer Profit Maximization vs. Capital investment decisions of a firm have a direct relation with wealth maximization.
All capital investment projects with an internal rate of return IRR greater than 1 or having positive NPV creates value for the firm.
In other words, these projects maximize the wealth of the shareholders because they are earning more than what they can earn by investing themselves. But, what is the real source of wealth creation?
What is that characteristic of the project which becomes the root cause of value creation? Source of Wealth Creation Normally, two types of environment are faced by us — one is external and other is internal.
If both the conditions support an organization, it tastes the success. A most important external factor which creates value is industry attractiveness and a similar internal factor is the competitive advantage of the firm.
Two main sources of wealth creation or value creations are the industry attractiveness and competitive advantage of the firm. Let us discuss them in little more details. Industry Attractiveness One of the most important factors for a firm to make profits is its industry attractiveness.
Explained by Michael Porter, there are five forces of industry attractiveness which are as follows: Higher the entry barrier, higher is the chances for a firm to sustain for a long term.
Lower the substitutes, lesser are the chances of consumers switching the products. Bargaining Power of Buyers: Lesser the bargaining power of buyers, the firm becomes in a better position to dominate terms. Bargaining Power of Suppliers: Lesser the bargaining power of suppliers and buyers, the firm becomes in a better position to dominate terms.
It emphasizes the degree of competition which exists between the current competitors of the industry. Amicable conditions among the competitors would make the firms enjoy the better position.
Competitive Advantage There are two elements of competitive advantage as per Michael Porter which are cost advantage and differentiation advantage. Cost advantage means the cost at which a firm producing the goods cannot be produced by the competing firms at that cost.
Due to this advantage, the firm can sell products at a lower price than the competitors and still earn profit out of that.
The firm enjoys good sales which lead to more profits and better cash flows and therefore achieve wealth creation. The customers are convinced with a different product which is available only with the firm under concern.Simply put, if philanthropy can create wealth for shareholders, other discretionary corporate social initiatives should create wealth by the same basic mechanism.
suggests that the type and scope of activities advocated by business citizenship scholars can generate shareholder wealth. Thus, while the risk management model presented here. Risk management & Shareholder wealth Lee Sook Hooi Tan Ser Sze Tay Teck Ming Determinants of business value Risk Management Framework There are 4 elements in risk management.
Management risk is the risk — financial, ethical or otherwise — associated with ineffective, destructive or underperforming management.
Management risk can be a factor for investors holding. In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
Essentially, risk management occurs when an. Chapter 20 Risk Management and Shareholder Wealth FIGURE The _ Risk management activities like insurance purchases and loss control expenditures typ %(1).
Article: Financial Management and Shareholder Value By Dr. Valerio Potì, Examiner: P2 Strategic Corporate Finance optimal capital structure and an optimal risk management policy even without agency costs shareholders wealth, that positive NPV projects will be passed up.