FIN211 Financial Management and Risk Averse Finance Managers

1.The concept of risk aversion suggests that finance managers should only invest in risk­free assets’. Critically evaluate this statement (indicate whether you agree or disagree in your answer).

 

2.Explain why the concept of ‘maximisation of shareholder wealth’ is critical to a firm. Contrast this concept with the notion of ‘maximisation of profit’.

Question a.

‘The concept of risk aversion suggests that finance managers should only invest in risk-free assets’. Critically evaluate this statement (indicate whether you agree or disagree in your answer).

Answer:

The definition of risk averse itself clarifies that it means anybody who is avoiding risk but this definitely do not mean that the person do not take any risk. In the case of finance managers whose prior consideration is to manage funds of the organization it becomes a challenge for them to invest in risky assets. As they deal with the borrowed funds wherein they are required to pay interest on the same it becomes a challenge for them to invest the funds in less risky assets and generate good return out of the same. Let us take an example for the same:

Considering the fact that the finance manager is risk averse hence he would prefer to invest in less risky assets (Kendrick, 2015). There are two companies in which the finance manager can invest the funds. Company A which offers a higher rate of return but is not providing with a fixed rate of return. On the other hand he has an option to invest in Company B wherein he is getting an option of getting fixed rate of return but the rate of return is quite low as compare to Company B. The finance manager will always go with company B although he is getting a lower rate of return as the amount of fund involved is quite high.

We can consider another example for risk averse finance managers. If the manager is getting options of investing in two different companies wherein the rate of return from the amount invested is same in both the companies however the risk differs in both the companies, the finance manager will always prefer to invest in the company wherein there is minimal risk or no risk and the rate of return from the fund invested is guaranteed. The finance managers will even not consider the options of finding a mix and match of the risk involved and the return expected.

Where the finance managers are ready to take risk and invest in risky assets as well as non- risky assets, the primary consideration which arises here is the rate of return the manager is expecting to get by investing in risk free assets (Wheeler, & Swick, 2011). Based on the above factor the percentage of investment in risk free investment alongwith the risky asset is determined. If there are chances wherein the manager can protect the amount invested in risky assets with the help of some insurance, the additional cost arising on the part of insurance is deducted with the return being expected from risky assets. The final rate is arrived only thereafter which is the fixed rate of return being expected out of a portfolio drawn in the case of a risk averse finance manager. However the finance managers on a broader view instead f considering the investment in varied risk and risk free investments always prefers to invest in treasury bills as issued by the Government of the relevant country. Broadly investment in treasury bills is only considered as investment in risk free assets.

However I disagree from the view that the managers should invest in risk free assets as investing in the risky assets with some conditions may lead to higher rate of return as compared to what we are expecting from risk free assets. For this we can consider the third example wherein the manager had an option to take insurance of the fund invested in the risky assets

Question b.

Explain why the concept of ‘maximization of shareholder’s wealth’ is critical to a firm. Contrast this concept with the notion of ‘maximization of profit’.

Answer:

By maximization of shareholders wealth we generally understand increase in the net worth of the shares held by the shareholders which generally is the result of the increase in the market price of the shares held by the shareholders.Due to the increase in the market price of the shares event the value of the firm also increases (WITZANY, 2017). Some of the ways in which the organization may increase its shareholders wealth are new investments, dividend policy, corporate strategy with only interests of the shareholders in its mind and compensation policy.All the shareholders put their money in the shares of the company only with the expectation to increase their value of money. However the concept of maximisation of profit means processes whether it be long term or short term by which the entity determines the output level and the price of the products it is dealing into to provide the greatest profits. Both the concepts though interlinked are different from each other.A major factor which affects both shareholders wealth maximization and profit maximization is the social responsibility of the entity. Only if the entity will be socially responsible then only this will be able to gain the confidence of the shareholders. While the concept of profit maximization is a short term goal because in the longer run it will lead to non- compliance of the social obligation of the entity.

While the concept of profit maximization is a short term goal as it is achievable but at the cost of future of the business as the long term sustainability of the business might get affected due to the wrong decisions taken in achieving higher profits (Hillson, 2011).

While the wealth maximization concept is more dependent on the risk and uncertainty factor for the discounting rate to be calculated. Hence higher is the risk, higher is the discounting rate.

The concept of wealth maximization is based on the cash flows and only on the profit s of the organization whereas the concept of profit maximization is based entirely on the profits of the company.

Since the aim of the management is in most of the cases to increase the profits of the organization but the organization should aim at minimizing the wrong doings for reaching a higher profits. As wrong doings in the short term would lead to higher profits but in the long term it would lead to fines, penalties, loss of reputation , trust among the shareholders which will automatically lead to lowering of the stock market prices. As a result of which the company would have to incur a lot of expenditure on the compliance costs.

However it is very clear that though it not easy for the management to create both maximization of the shareholders wealth as well as maximization of the profit as one achievement can be achieved at the cost of the other as no organization can create value for the shareholders at the cost of the stakeholders i.e. customers, suppliers, bankers, government etc. However keeping in ming the profit maximization the basic necessity of the shareholders wealth maximization as discussed above should not be forgone.

References:

Hillson, D. (2011). Managing risk in projects (1st ed.). Farnham, Surrey [u.a.]: Gower.

Kendrick, T. (2015). Identifying and Managing Project Risk (1st ed.). Amacom.

Wheeler, E., & Swick, K. (2011). Security Risk Management (1st ed.). Amsterdam: Elsevier Syngress.

WITZANY, J. (2017). CREDIT RISK MANAGEMENT (1st ed.). [Place of publication not identified]: SPRINGER.