0:03 this is a lecture from open tuition to
0:05 benefit from the lecture you should
0:07 download the free lecture notes from
0:09 open tuition comp we now move away from
0:11 the section of the syllabus that dealt
0:13 with strategy
0:15 and on to the section of the Stratus
0:19 syllabus which deals with risk and first
0:24 of all we need some definitions risk is
0:27 a condition in which there is a
0:31 quantifiable this version of the
0:36 possible outcomes so quantifiable in
0:38 other words if you're dealing with risk
0:40 strictly speaking you can attach
0:49 probabilities to what's going to happen
0:52 so if you're developing a new product
0:54 the new product could either sell well
0:57 it could sell badly if you can say well
1:00 I think it's gonna sell well excuse me
1:02 with a probability 0.7 and bad with the
1:06 probability 0.3 then you are in the area
1:10 of risk so quantifiable dispersion and
1:12 of course there are different possible
1:15 outcomes success/failure high cost low
1:24 uncertainty is really were you don't
1:27 have the quantifiable probability
1:31 statistics you know the things could go
1:34 bad or could go well but we haven't got
1:37 any information about the relative
1:39 likelihood of them going bad or going
1:44 well we're working much more on the dark
1:47 insurance company's work with risk so
1:49 insurance companies have all sorts of
1:52 statistics about the chance of a 30 year
1:56 old male having a car accident compared
1:59 maybe to the the chance over a 40 year
2:01 old female and and so on and of course
2:03 they can also based on your driving
2:07 record and so on they have a risk figure
2:10 in mind which is going to determine your
2:14 Premium so may Life Assurance they have
2:17 all sorts of statistics about the if
2:20 somebody is fifty years old the
2:21 probability that they're going to be
2:25 alive and say 25 years or 30 years or 35
2:29 years and it depends on male/female it
2:31 depends on baby
2:32 previous health issues that they would
2:35 have it depends on where they live and
2:37 so on but they've got this really
2:41 detailed information about the
2:43 probabilities of survival and again they
2:47 can use that to determine life insurance
2:50 premiums or pension annuities and the
2:55 like when we come to really consider the
2:59 the almost the impact of risk it is
3:00 really good
3:04 got two components to it there is a
3:06 probability that the event will happen
3:10 and then there is the consequence or the
3:12 consequences that take place if it does
3:16 happen so the two kind of areas we'll be
3:19 looking at there or we can look at is
3:21 you could have an event which is very
3:25 unlikely and if the consequences were
3:28 quite severe you might decide to put up
3:30 with it
3:32 so you know when you're crossing a road
3:35 there is a chance that you will be
3:38 knocked down and the consequences are
3:41 very severe but on your own mind you're
3:43 doing a little kind of calculation and
3:44 say well I could be killed crossing the
3:47 road but actually the probability of me
3:49 being killed crossing road is terribly
3:51 small and we clean it would cross the
3:56 road multiple times a day or there could
3:57 be a high probability of something
4:00 happening and the consequences are
4:05 relatively small so high probability
4:08 maybe of something happening is that you
4:11 know when you're washing up a cup of
4:14 something maybe you drop it or you chip
4:17 it on the tap but by and large it's a
4:19 fairly trivial event and we just don't
4:20 kind of worry about
4:23 that where we get particularly worried
4:25 as well as high probability now high
4:29 consequences so we know there's a high
4:32 probability of the event occurring and
4:34 in particular the consequences are going
4:37 to be very bad there may become maybe
4:41 quite worried about that so many people
4:44 will for example maybe not undertake any
4:47 sort of adventure sports or dangerous
4:52 sports because you know if I begin that
4:54 they in their mind because we've got
4:56 different perceptions of risk if I begin
4:59 skydiving or rock climbing or something
5:02 there is a substantial risk I'm going to
5:05 fall and if I do fall then the
5:08 consequences could be severe and so they
5:10 avoided other people I've got quite a
5:12 different perception of what the risks
5:16 might do and of course and of course
5:19 something is very important and risk is
5:23 you can often control it so in rock
5:25 climbing you essentially control the
5:29 risk or can control it by using ropes
5:33 and alike and you bring the risk down to
5:38 maybe something which is acceptable some
5:40 more little bits of the terminology
5:44 downside risk is a possibility of a loss
5:47 and and if there is no possibility of
5:50 any gain and there's only loss the
5:54 religious pure risk so pure risk is near
5:56 coming from a fire so fire in your home
5:59 of fire offers no good things are going
6:01 to come from ideas pure risk it is
6:06 certainly downside risk another example
6:10 would be a virus that could be a virus
6:12 in your body if I'm talking about a
6:15 computer virus there's really no good
6:18 news and by getting a computer virus and
6:20 that risk is pure risk it is all
6:24 downside absurd risk is a possibility of
6:28 a gain and of course the the upside risk
6:30 the possibility of the gain
6:35 is perhaps when you get a new product we
6:38 launched a new product with the hope for
6:40 that it will sell well and make us again
6:43 because we're not certain and by far the
6:46 most common form of risk is respective
6:50 to the risk where things can go both ways
6:50 ways
6:53 so if invest in shares they could go up
6:56 and go down if you change money into
6:57 foreign currency it can get more
7:01 valuable less valuable if you launch a
7:04 new product it could go well it could go
7:08 badly happen and so on so most risk will
7:10 come across is going to be speculative
7:13 risk and we talk about risk we tend to
7:16 think of any downside risk we we focus
7:18 on on the bad things but strictly
7:21 speaking risk is a usually a two-way street
7:22 street
7:25 risk will take into account also the
7:32 possibility of things going well what
7:34 we're doing in business or almost any
7:40 activity is really balancing risk and I
7:43 suppose return if in business certainly
7:47 you take no risks whatsoever you don't
7:49 develop any new products you don't try
7:52 to go into any new countries and so on
7:54 then you're not going to make much of a
7:57 profit if you're not going to take any
8:00 risk whatsoever but anything you can do
8:02 commercially is maybe put your money in
8:06 a very safe bank account and just earn
8:09 very small amounts of interest but most
8:13 companies want to develop products
8:17 develop markets and gain customers and
8:19 so on and as they're gonna do that they
8:22 have to incur some risk you have to take
8:24 the risk of deciding maybe to open in
8:28 America it might not work but if it does
8:29 work then of course we've got a vast
8:33 population who could provide new
8:35 customers to us
8:39 however this always requirement and as
8:41 almost an unnatural activity of
8:45 entrepreneurs to want to take risk has
8:47 to be kept within bounds a sturdy
8:50 conformance that we don't want the
8:52 company to be taking if you like
8:57 outrageous risks undertaking projects
9:00 which if they fail could lead to the end
9:03 of the company so we have this balance
9:07 between what's called performance taking
9:08 a risk and I hope we're going to get
9:11 better province bright profits and
9:14 conformance conformance that we can of
9:19 control people's risk taking that we
9:21 mitigated that we stopped spending more
9:23 money and a project if it seems to be
9:26 irredeemably bad and so on and their
9:28 compliance with the rules and
9:30 regulations to limit the risk is
9:34 necessary but generally speaking higher
9:38 risks are going to be needed to produce
9:42 higher returns and all of the argument
9:44 is about how much higher shoot those
9:48 risks be and there is no single answer
9:55 to that what we can do here is look at
9:58 the the risks you might undertake look
10:01 at the competitive advantages return the
10:04 possibility of increased profits if you
10:09 like and some things are routine we're
10:12 not going to get much extra profit but
10:15 it's not gonna be much extra risk so it
10:17 could be signing up a a small new
10:19 customer and giving them a small credit
10:22 limit so not going to buy very much from
10:25 us at the start there's a risk that they
10:27 don't pay us but of course if we put a
10:28 credit limit on that
10:31 that's the compliance bit of it then the
10:35 risk of they go bad is low and even if
10:37 they do go bad we're not going to lose
10:42 it that much if it's high and high we're
10:44 going to avoid it a big one of it's a
10:46 high risk but low return
10:48 then it's obviously something to avoid
10:52 so if we were thinking maybe we should
10:55 develop a new product but actually the
10:56 market for that new product is very
11:00 small why would we want to take this
11:02 high risk that the development of the
11:05 problem might fail if at the end of the
11:07 day it's only gonna sell you know a few
11:09 hundred units a year and the extra
11:10 profit is going to be trivial
11:13 you'll probably decide not to even start
11:17 developing that product if we're high
11:20 and high so maybe developing a new
11:24 product but now if it comes off there's
11:27 gonna be a vast new market and a really
11:30 high return or increase in our
11:34 competitive advantage that's what we
11:35 need to look at Caffe that's where we
11:37 really come up against the the balancing
11:41 which is going on here high risk we
11:43 spend a lot of money up front but you
11:44 know we might have to write it off
11:46 because it doesn't work but in the other
11:50 hand there are perhaps riches at the end
11:53 of the day and this is a sort of thing
11:55 where you know that there are certain
11:58 strategies that maybe we say well after
12:00 year let's see how the project is going
12:03 if it seems to be on stream if the costs
12:04 seem to be controlled till it seems to
12:06 be technically feasible well go on with
12:09 it but if at the end of the year when we
12:11 review the project then maybe that's
12:14 when we decide to pull the rug and not
12:18 to do anything more with it this is
12:22 great this is a kind of no-brainer
12:24 there's low risk and the possibility of
12:26 high return then we're going to go for
12:31 that so if for example a distributor in
12:34 a foreign country said look our
12:37 population really wants to your product
12:40 why don't you export your product to me
12:43 all you have to do sell it to me I would
12:44 look after all the distribution and
12:46 marketing in my own country because I
12:49 know about that and then you're into
12:51 probably this this come on almost golden
12:54 quadrant here there's relatively low
12:57 risk you could maybe take out credit
12:59 insurance you can make
13:01 have you even paid in advance by this
13:05 overseas agent so you're not exposed
13:06 very much to risk but the overseas
13:10 market particularly when dealt with by
13:14 this agent who knows what they're doing
13:17 it could really bring on very very high
13:21 extra returns extra profits and you
13:26 definitely go for that the risks are
13:30 categorized into any form and types the
13:32 first two are going to be strategic and
13:36 operational risks and the first one
13:39 we've got here are strategic risks and I
13:40 think of what we've always said about
13:43 strategy it's kind of long term and the
13:46 street a strategic risk is really going
13:49 wrong in the long term making sort of
13:52 rather fundamental errors perhaps in our
13:54 decisions or rather fundamental things
13:58 happening the market had an example
13:59 maybe or face
14:02 company which has suffered from a
14:06 strategic risk what we have the company
14:07 we mentioned right at the start of the
14:14 the kind of lectures Nokia so Nokia did
14:18 very well but then essentially the long
14:21 term technology changed people went for
14:24 smartphones and and so on and no Korea
14:29 didn't alter its position in the market
14:32 quickly enough a Kodak was another one
14:35 of a strategic risk suddenly the product
14:37 that was our breadwinner and a very
14:39 profitable product nobody wanted it
14:43 anymore what can cause it it can be the
14:45 Lance and outdated technology maybe like
14:49 Kodak competitor action maybe a
14:51 competitor's suddenly develops a better
14:54 product and we're kind of left standing
14:57 reliance on a declining market or maybe
14:59 we have too much of our operations in a
15:03 declining country country which is gone
15:06 into economic recession and so on
15:10 and really eats into our profitability
15:13 reputational risk over perhaps a number
15:16 of years has been a few scandals and
15:19 people can look at us and say well it is
15:21 that wrong in that year the next year
15:24 that did that wrong what else is is kind
15:27 of kind of skeleton to come out of the
15:30 closet and so on I just don't trust
15:33 those people anymore and I suppose we
15:37 could think maybe a Volkswagen fantastic
15:40 reputation and then there was the
15:43 scandal about Miss reporting emissions
15:46 from particular diesel cars but also
15:50 other cars and suddenly you know they
15:52 were at great reputational risk they
15:55 seem to have done okay but it was very
15:59 expensive fallen how perhaps financial
16:02 risks you borrow too much your interest
16:05 burden is too great your profits fall a
16:07 little bit and suddenly you can't pay
16:15 operational risks are much shorter term
16:17 risks they're almost day-to-day things
16:21 that go wrong so examples could be human error
16:22 error
16:24 some of the pressing the wrong button on
16:27 a machine or deleting important files in
16:29 the computer that those are operational
16:33 risks a machine breaking down so begins
16:35 producing products which are faulty that
16:39 is an operational risk fraud
16:41 non-compliance with regulations
16:43 probably an operational risk if it's
16:47 just a slip it could be a strategic risk
16:50 that there was a deliberate policy from
16:54 the top to try to deceive government and
16:59 regulators loss of key people and the
17:02 occasional DEP going bad are kind of
17:06 operational risks which we have to
17:10 really cope with
17:12 then we have reporting risks the
17:16 reliability of reporting there is a risk
17:18 that our financial statements is wrong
17:20 there is a risk that if you have to send
17:22 in returns the government may be about
17:24 employment something of that sort you
17:26 know that's sort of information wrong
17:27 and so on
17:29 I would say that by and large off the
17:31 four kind of risk categories we're going
17:34 to be talking about probably reporting
17:36 risk is it's going to be embarrassing
17:38 but it's probably could it be the
17:42 cheapest probably and finally there is
17:46 compliance risk compliance is where you
17:48 failed to comply with rules and
17:52 regulations and this can be very very
17:57 expensive there can be fines and
17:59 sometimes governments would put on
18:02 what's called punitive fines finds it
18:05 very very high to punish you and to act
18:09 as a deterrent for others there could be
18:15 damages so if you don't comply with
18:18 health and safety regulations and one of
18:21 your workforce gets badly injured then
18:23 you're gonna have to pay that person
18:27 damages and then sometimes there can be
18:34 you can actually lose your license so in
18:38 the UK as in most countries our
18:42 restaurants are inspected to ensure that
18:46 they comply with basically food hygiene
18:50 regulations and if an inspector goes in
18:53 and finds that the the kitchen is disgusting
18:55 disgusting
18:59 really then the regulatory authorities
19:03 can ban the restaurant from trading and
19:05 can either ban it from trading until it
19:07 cleans stuff up or if it keeps repeating
19:11 it can ban them permanently from trading
19:14 and so on so potentially very very
19:21 all we have in the next few slides and
19:23 indeed in the notes it's just a big list
19:24 of potential risk you don't have to
19:27 learn what these are it's just showing
19:30 you that there are many many different
19:35 forms of risks so an environmental risk
19:38 could be that you release nasty stuff
19:41 into the river and probably then
19:46 trigging a kind of a regulatory problem
19:48 economic risk that may be the exchange
19:50 rate moves against you and you found it
19:53 hard to export or you find the imports
19:57 are very expensive going further on down
20:01 here we have financial risk coming in
20:03 currencies changing interest rates
20:07 changing and and the like has loads of
20:12 IT risks viruses hacking machines simply
20:14 breaking down and you're not being able
20:16 to trade for several days because a
20:19 programmer has made an error in the
20:25 updates knowledge management that a some
20:28 key personnel leave and when they leave
20:31 they take with them knowledge which is
20:33 very important to the business and the
20:36 businesses left / EFT
20:39 property risks obviously the property
20:42 could burn down it could be flooded
20:44 those are property risks but it can also
20:47 be that you have bought property and
20:50 been trading with it for some years
20:53 maybe a shop and then you find that the
20:56 area of the town which the shop is
20:59 situated has become unfashionable for
21:00 people now feel it's it's a bit
21:02 dangerous to go to that area of the town
21:05 and you're left with this property which
21:08 is kind of in the wrong place and
21:10 there's a risk therefore that it's not
21:13 going to be really earning its keep
21:16 other ones here just a couple of these
21:18 health and safety risks I've talked
21:21 about already having to pay damages and
21:24 so on a trading risk perhaps that a
21:28 major customer takes business somewhere
21:30 you could also bring in their bad bad
21:32 debt risk the categorization doesn't
21:35 matter very much resource risks you find
21:38 it difficult to find enough raw
21:41 materials because the raw materials are
21:44 very difficult to find or maybe the
21:47 country that produces them is going
21:50 through some sort of political turmoil
21:55 Ford risks that your staff are stealing
22:00 from you basically probity risks that
22:02 your staff maybe have embarked on
22:09 providing maybe bribes to customers to
22:11 get big orders coming in and of course
22:15 when the the bribery is discovered again
22:17 you're going to be in for huge penalties
22:23 potentially now almost getting back to
22:25 this core conformance performance
22:29 balance of God's here a very important
22:31 concept and one you have to understand
22:35 really is risk appetite as it says here
22:37 risk appetite it's a nature and strength
22:42 is at risk that we are willing to bear
22:47 some organizations are risk seeking and
22:52 some are risk averse and it isn't there
22:55 one that's right and one is wrong what's
22:57 particularly important is that they
23:00 don't tell lies to their shareholders so
23:02 if you say to your shareholders we are a
23:06 company which which takes risks you know
23:07 inevitably our business is going to be
23:10 one where we take risk we are developing
23:13 pharmaceuticals we pump millions of
23:15 dollars into this and then may be fine
23:16 it's not going to work
23:19 it could be a bit of a bumpy ride and
23:20 provided the shareholders are happy with
23:24 that that's fine other companies will
23:29 say we release a fog via money we will
23:32 maybe be in food distribution
23:35 supermarket company supermarket
23:37 companies tend to give thoroughly stable
23:39 earnings with everyone needs to eat and
23:40 so on
23:42 and they provide a day they stay true to
23:45 that they just stay in the supermarket
23:47 business they don't start diversifying
23:51 into other risky areas that that is fine
23:56 as well the two things that make up the
24:00 risk appetite how much risk are we
24:04 willing to bear basically how do the
24:09 second one first it is risk capacity the
24:12 nature and strength of the risk that the
24:18 organization is able to bear for example
24:27 what are its cash resources if you have
24:30 lots and lots of money in the bank and
24:33 you embark on some sort of speculative
24:36 development of a new product and the new
24:38 product doesn't work okay you've spent a
24:40 lot of money but nevertheless you're not
24:43 going to go into liquidation because you
24:44 still have lots and lots of money in the
24:48 bank you have almost the flexibility to
24:53 gamble safely if however you've got for
24:55 example relatively little money in the
24:58 bank and you embarked on a big project
25:04 and the big project fails then that
25:05 could be the end of you
25:08 because you've kind of bet the company
25:12 really on this project working and it
25:13 could be exactly this is the same
25:16 project in both situations but in the
25:18 the well-off company it can stand to
25:21 lose that money in the less well-off
25:24 company it's going to be really dealt a
25:27 fatal blow if it loses had money
25:32 so it's risk capacity and secondly you
25:36 have the risk attitude the directors
25:41 views daily these views here should
25:51 the directors views of the amount of
25:52 risk that the shareholders and they
25:55 think the shoulders are willing to bear
25:58 you could have a company with lots of
26:00 money in the bank it could kind of
26:03 gamble a new project safely but actually
26:05 the shareholders that what that the
26:07 shareholders more than nice safe home
26:13 for the savings alternatively you could
26:14 have a company with lots of money in the
26:16 bank and the shareholders kind of their
26:18 want out they they they say you have to
26:21 go out you have to push the boat out you
26:23 have to try to develop new products I
26:25 want to see growth and I'm willing to
26:28 undertake a bit of a loss I know that's
26:32 what it takes so the two things are as
26:33 how much can we afford to lose and
26:36 secondly really what is the risk
26:39 attitude author directors but ultimately
26:41 that should be reflecting the risk
26:45 attitude of the shareholders people who
26:51 own a company benefits of risk
26:54 management is going to be first of all
27:01 more predictable cash flows if you give
27:05 your credit limits for example to
27:07 customers and one of them goes bust then
27:09 you've limited the damage the cash flow
27:11 is going to be a bit adverse but it's
27:14 not going to be deadly adverse if you
27:17 like if instead of maybe opening a
27:21 hundred branches in a new country at
27:25 once you open ten branches see how they
27:29 go they go well then you extend your
27:33 operations in that new country again you
27:36 are having more predictable cash flows
27:40 particularly this downside risk it
27:42 applies well run systems because
27:44 somebody has sat back and thought about
27:46 risk and thought about cash flows
27:49 thought about the upside and the
27:52 downside that might come through if you
27:56 don't have any form of risk management
27:59 it's almost other people go into
28:03 projects or ventures without probably
28:05 really thinking about them and
28:10 evaluating them properly limitation of
28:11 the impact of disaster
28:16 so a risk management it a very simple
28:20 obvious one is some smoke detectors a
28:23 very simple one is if you're reliant on
28:26 your computer a standard risk management
28:27 technique apart from keeping that
28:30 computer secure is if another computer
28:33 probably in a different town mirroring
28:37 the records on your main computer so one
28:40 goes down gets damaged the other one
28:42 just kind of starts off immediately
28:47 seamlessly and trading continues greater
28:49 confidence amongst almost everyone
28:52 involved with the organization investors
28:54 Louie's customers suppliers and partners
28:57 and so on here and there's greater
29:01 confidence here if you believe that the
29:06 risk is down then this is going to
29:10 should say well my costs are going to be
29:14 down I'm not going to lose as much
29:17 unexpectedly I'm not going to come in
29:20 for fines and damages and so on from
29:23 people go it's more more predictable
29:25 kind of cash flows and what you should
29:27 find here is your cost of capital is then
29:36 so when you go to the bank and want to
29:38 negotiate an overdraft or a loan one of
29:40 the things they will think to themselves
29:43 is is this a risky place to lend money
29:46 to and if you can show that you are
29:49 managing your risks well that your
29:51 chances of something big and nasty
29:56 happening unexpectedly is low that
29:58 you're there for nearly always be able
30:01 to pay the interest then the bank will
30:04 lend you the money to the lower rate
30:06 similarly if you go into people and
30:08 asking for share capital you can say
30:10 well look you know we're very cautious
30:13 we're taking some risks but nothing
30:16 really nasty is gonna happen and with
30:17 those risks were built in nicely
30:20 increase our dividends and so on then
30:23 people will be willing to invest in you
30:26 more readily and more cheaply than they
30:29 will invest in a in a company where the
30:32 earnings are very erratic where the
30:34 track record is very lumpy and so on
30:37 dividends kind of going up and down and
30:40 coming in the headlines or doing things
30:43 wrong and so on the lower the cost of
30:45 capital then the higher the share price
30:52 should be the share price will be up
30:55 then the present value of any project
30:59 should also be increased and finally
31:02 better matching of the risk appetite of
31:04 the shareholders what the company is
31:07 actually doing you need to be fair to
31:09 shareholders you need to say look if
31:12 your investor narcissus is sort of
31:14 company we are these are the sort of
31:17 risks we undertake these are the sort of
31:19 safeguards maybe we put in to make sure
31:21 we don't lose too much money
31:24 are you interested investing in a
31:26 company with that sort of risk profile
31:29 what we don't want to be doing is is
31:32 kind of luring shareholders into a
31:34 company and then then finding it's
31:38 really not the type of risk return
31:40 balance that they're going to be happy
31:43 with and we have to find this acceptable risk
31:44 risk
