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Please provide your insights on the following questions:
- Define financial risk. Why is risk analysis so important to capital investment decisions?
- What is meant by the term capital rationing? From a purely financial standpoint, what is the best capital budget under capital rationing?
Respond: When it comes to financial risk it, I like to think of a real-world example. What comes to mind is gambling. Or the show Shark Tank where people pitch their product and hopes to leave with an investor/partner, but the sharks must really think strategically they make their decision based on the fact that is the product going to be profitable and will the shark profit on their investment? Well, it is the same thing for healthcare as well. “The additional risk to owners (or to the community in the case of not-for-profit organization) when debt financing is used is called financial risk” (Reiter and Song, 2018, p.231). I think the reason why a risk analysis is so important to capital investment decisions is because there is a lot of money that is at stake and the fait of an organization is also at risk. “The higher the risk associated with any investments, the higher its required rate of return” (Reiter and Song, 2018, p.292). What is meant by the term of capital rationing, “Capital rationing is the condition of having more acceptable projects than funds (capital) needed to undertake those projects” (Reiter and Song, 2018, p.306). So basically, putting a restriction on the number of investments because the expectations on the return on the investments are poor. It makes plenty of sense that the best capital budget would be one where the company is not losing money but an investment they will do well with.
Respond: Financial risk is not conceptually that different from the risk we know and (probably don’t actually) love, it is exposing yourself to the potential of an unfavorable event, whether that be a risk of physical injury or one of financial injury. Financial risk is defined by the “probability of earning a return less than expected” (Reiter & Song, 2018). This means if there is a possibility of an investment producing a rate of return that is 100% on a $100 investment, meaning you would recoup your initial $100 and an additional $100, however there is also the chance of losing the initial $100 investment, than this investment would be financially risky because there is a possibility of not making an return and losing the invested money. Qualitative risk assessments can be a useful tool in risk analysis, even though it may appear quite subjective initially; this assessment involves asking a series of questions regarding the new project, essentially determining the level of difficulty surrounding the project that are not in stark financial terms such as if the new project involves stepping outside the organizations current expertise or if the new project will put the organization in direct competition with a strong competitor (Reiter & Song, 2018). Although these are not objective numerical values related to the project, the greater number of “yes” answers to the qualitative risk assessment questions results in increased uncertainty of cash flow and therefore a greater overall financial risk (Reiter & Song, 2018).
Most businesses function under the assumption that they can raise capital for any needs, as long as the business is investing in profitable projects (Reiter & Song, 2018). This however is untrue for not-for-profit businesses, and thus they will likely face a time in which they require capital for investing in new projects, but lack the sufficient capital available, and this is called capital rationing (Reiter & Song, 2018). The best capital budget in this case is to invest in projects that have the most financial gain to be had. This simply means investing in projects that maximize aggregate net present value to meet their needs in terms of capital (Reiter & Song, 2018). This does not mean that other projects that may not make as much money, or may in fact lose money, should always be pushed aside. It is important that not-for-profit organizations invest in projects that fulfill their mission, however there must be sufficient capital, and that capital must come from somewhere, and therefore there must be other, higher gaining projects to offset these mission investments (Reiter & Song, 2018).