Value of risk refers to the financial benefit that an organization will gain for pursuing a risk-taking activity. Businesses undertake different activities all the time – such as starting a new product line, opening a new retail store, entering into a new geographical market, etc. – and all the activities carry a certain level of risk.
The level of risk involved in any activity depends on the ability of the business to recover all costs incurred in pursuing the activity. Also, each activity carries a different level of risk, and it the responsibility of the management to determine whether a selected activity will help the business achieve the desired objectives. Value of risk considers the individual components of the cost of risk to determine if a risk-taking activity adds to the shareholder value.
Value of risk refers to the financial benefit that stakeholders of an organization gain by pursuing a risk-taking activity.
The amount of risk involved in any activity depends on the type of activity and the ability of the company to recoup costs incurred.
Each activity carries an opportunity cost, which is the benefit foregone by spending money on one activity instead of other activities with a potential benefit.
Understanding Value of Risk
Businesses face limited resources, and the management must make smart decisions to generate returns for investors. The management must make calculated moves on the risk-taking activities that the business chooses to implement. Regardless of whether the activities will be a success or failure, the value of risk includes an element of opportunity cost.
Spending money on one activity carries the opportunity cost of time and the money spent – i.e., the money spent cannot be utilized on a different activity. For example, if a company invests $50 million in a new product line and the product line fails to generate the expected returns, the opportunity cost lost represents all the activities that the business could’ve achieved with the $50 million capital.
When pursuing risk-taking activities, businesses need to consider the risk of outside factors and future viability of the activities. For example, luggage companies explored the possibility of inserting microchips and batteries into luggage as a way of tracking the luggage if it ever got lost. The companies banked on the technological advancement to provide a solution to a problem that travelers often encounter when transiting through airports.
However, the smart luggage idea did not last for long after airlines rejected the idea of inserting microchips and batteries into the luggage for safety and security reasons. Airlines rejected the proposed idea on the basis that the smart luggage presented the risk of battery fires, and they were subsequently banned in the United States.
As a result, most smart luggage companies that initially invested in the innovation incurred huge losses and were forced to liquidate. Had the manufacturers determined the risk before undertaking the activity, they could’ve invested the capital in other risk-taking activities that are not largely affected by market regulations.
Cost of Risk Components
The cost of risks refers to all the costs incurred in managing risks and the associated losses. It is the sum of all elements of a business related to risk, including the uninsured retained losses, risk control costs, transfer costs, loss adjustment expenses, the cost of mitigating risks, and the cost of administering a risk management program.
The costs are calculated for each financial period. Each of the components of the cost of risk is treated as an investment option, and it must show a return on investment.
For example, a company may allocate a proportion of its annual budget to its risk management department as a way of managing risk exposure of the company. The management entrusts the personnel in the risk management department with the role of identifying any risks that the company faces.
The department is also tasked with coming up with ways of managing the risk exposure before the company incurs a loss from it. The budget allocation to the department will be considered beneficial if the cost incurred in managing risks is less than the earnings that the company gained during the period.
How Business Risk Works
Business risk is the exposure of a business to any factors that may cause a decline in its revenues. It includes any factors that threaten the company’s ability to achieve its target financial goals. The risks may come from within the company or due to external factors that it cannot control.
Although companies may not be able to completely protect themselves from the risks they face, there are steps they can take to respond appropriately and reduce the risk exposure. The main types of business risk include:
1. Internal risks
Internal risks are caused by factors within an organization. Since these risks arise from sources within the organization, the management can take action to manage internal risks. Examples of internal business risks include union strikes, ineffective management, obsolete technologies, server problems, damage to company assets, etc.
2. External risks
External risks are factors that arise from sources outside the organization, and they cannot be controlled by the company. Also, unlike internal risks, it is impossible to predict the occurrence of external risks with a high level of reliability. Examples of external risks are economic downturn, inflation, natural disasters, and political instability.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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