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.
To a large extent, the impact that risk has on the financial decisions of a company depends on the kind of financial decision being made. For instance, when it comes to capital structure decisions, a company could shy away from a high level of debt-to-equity ratio in an uncertain business environment (Fibozzi and Drake, 2009). This is more so the case given that significant debt could expose the company to a higher bankruptcy risk. The five examples of risk that a CFO ought to take into consideration have been highlighted below:
a) Interest Rate Risk: This has got to do with the effect of shifting interest rates as it could have an impact on many other factors such as cost of borrowing.
b) Financial Risk: This could relate to the financial leverage degree a company embraces
c) Regulatory Risk: This relates to regulation changes, i.e. on financial reporting requirements.
d) Tax Risk: This is risk associated with tax law changes, i.e. in relation to increase in tax rate.
e) Foreign Exchange Risk: This is risk that is largely associated with fluctuations in currency.
What is the difference between systematic risk and unsystematic risk? How are these two types of risks measured?
Systematic risk could be conceptualized as the risk that relates to, or impacts the market in its entirety (Adam and Gunasingham, 2020). It could be measured using a beta coefficient. On the other hand, unsystematic risk has got to do with risk that largely impacts an individual company, i.e. company-specific risk (Adam and Gunasingham, 2020). Standard deviation could be deployed as an ideal measure on this front.
Classify each of the following as an example of systematic or unsystematic risk.
a) The labor unions at Caterpillar, Inc. declared a strike yesterday. (Unsystematic Risk).
b) Contrary to what polls stated, the President was re-elected. (Systematic Risk).
c) Disagreement about inflation policy leads to a fall in the Euro relative to the dollar. (Systematic Risk).
d) The computer industry suffers lower profits because of aggressive pricing strategies on new desktop computers. (Unsystematic Risk).
Suppose the U.S. dollar strengthens in the past year against other currencies. Explain its effect on U.S. dollar revenues and expenses for a global firm headquartered in the U.S.
In essence, a strengthening US dollar would mean that 1 dollar now buys…
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