Principles of Finance I WEEK 8: Discussion Prompt #2 - Financial decisions, retu

Question

Principles of Finance I WEEK 8: Discussion Prompt #2 - Financial decisions, return, risk, and the firm’s value are all related. The world of finance is intertwined in the daily decisions that are made by the organization. For this discussion, consider a key event that is being considered at your company. This could be the launch of a new product, opening another location, etc. In your response, provide specific examples how these areas are related to the decision that the organization must make when deciding whether to move forward with this project.

Explanation / Answer

Financial Decisions always consider 3 major aspects of any event. They are the return, the risks involved and maximization of firm's value.

For Example, let's consider a Bank, X Bank, that has so far been dealing only with retail deposits. It only accepts deposits from Individuals and Family Trusts & only lends to individuals or Family Individuals. Due to this position, it has a very high CASA Ratio (also referred to as Liquid Deposits Ratio) and a very favourable Asset Quality. It has also developed a specialization in assessing credit worthiness of Individuals.

However, owing to this limited customer base, the asset base of X Bank has lagged behind other banks. That is because most of the large corporate clients were never a part of X Bank's clientelle. Their competitors have raced ahead, and the shareholders have now begun to question the bank's strategy of staying away from corporate accounts despite having sufficient capital to lend to slightly riskier assets.

Now, at once, this may seem like a mere business call. One may be believe that since the decision is about catering to new clients, this may not be considered a financial decision at all. After all, at the heart of it all, this is only like a new product launch. However, when we begin to look at this from a financial perspective, there are many financial variables that have to be considered for this. The Three prime factors like mentioned in the problem to be considered for this situation are as follows:

* Will catering to corporates cause the return on equity to rise?

* If yes, then is the bank prepared to lend to riskier & more complex structures, such as SPV's, Securitized Trusts etc.?
* Will this result in overall enhancement of the Bank's value for the Shareholders?

The Bank will decide the feasibility of this decision based on these 3 areas first, and will then move on to making business related decisions such as capacity building etc.

Likewise, any firm will have to consider the financial feasibility of its decisions based on the areas specified above.

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