Strategy: Analysis and Practice Slide 1/1 ©The McGraw-Hill Companies, 2005 Chapter 14. Risk, uncertainty and strategy

Strategy: Analysis and Practice Slide 1/2 ©The McGraw-Hill Companies, 2005 Outline Introduction What is risk? Organizational versus management risk Prospect theory and risk Dealing with uncertainty Risk analysis and assessment techniques Risk indices Scenario planning

Strategy: Analysis and Practice Slide 1/3 ©The McGraw-Hill Companies, 2005 Introduction Strategic decisions are taken in the context of uncertainty and risk. Decisions about future states of affairs are based on incomplete information. Strategic decisions involve large opportunity costs.

Strategy: Analysis and Practice Slide 1/4 ©The McGraw-Hill Companies, 2005 What is Risk? Possibility of destruction, loss or damage For business, additionally: Pure risk – likelihood of damage to assets and liabilities through fraud or criminal acts. Speculative risk – likelihood of gains and losses from which profit is hoped to accrue.

Strategy: Analysis and Practice Slide 1/5 ©The McGraw-Hill Companies, 2005 Risk The assessment, severity, amount and nature of losses which an action may incur whether such actions are generated within an organization or imposed upon it. Risk is the measurable consequence of uncertainty for an organization. (Strategy: Analysis and Practice, McGee Thomas & Wilson 2005)

Strategy: Analysis and Practice Slide 1/6 ©The McGraw-Hill Companies, 2005 Organizational and Managerial Risk Factors Managerial risk – managers make choices with uncertain outcomes. High aspirations, low expectations Heterogeneous top teams Equity ownership Slack

Strategy: Analysis and Practice Slide 1/7 ©The McGraw-Hill Companies, 2005 Organizational and Managerial Risk Factors (continued) Organizational risk – organizations face volatile income streams from unpredictable environments. Complex environments Scarce resources Dynamic environments

Strategy: Analysis and Practice Slide 1/8 ©The McGraw-Hill Companies, 2005 Prospect Theory and Risk Decision makers make choices between risky alternatives based on the magnitude and probability of outcomes. Outcomes evaluated as gains or losses from a reference point. Valuation of gains and losses varies (e.g. gains may be less valued than losses). Individuals’ valuations differ so they react differently to the same risk.

Strategy: Analysis and Practice Slide 1/9 ©The McGraw-Hill Companies, 2005 Macro & Micro Sources of Uncertainty

Strategy: Analysis and Practice Slide 1/10 ©The McGraw-Hill Companies, 2005 Risk Analysis and Assessment Techniques Assess expected net present value in terms of the probability of changes to key variables -plot NPV distributions. Decision trees – plot sequence of events and probabilities of each towards endpoint.

Strategy: Analysis and Practice Slide 1/11 ©The McGraw-Hill Companies, 2005 Risk Analysis and Assessment Techniques (continued) Limitations: Provide a false sense of precision. Require considerable detail. Over-reliant on past relationships between variables. Key parameters may be overlooked. Difficult to include ‘soft’ factors. Overlook varying perceptions of risk.

Strategy: Analysis and Practice Slide 1/12 ©The McGraw-Hill Companies, 2005 NPV Distributions

Strategy: Analysis and Practice Slide 1/13 ©The McGraw-Hill Companies, 2005 Decision Tree for Product Launch

Strategy: Analysis and Practice Slide 1/14 ©The McGraw-Hill Companies, 2005 Risk Indices Specialist organizations draw from expert opinion to compile indices on risks associated with major variables. General classification of countries for foreign investment.

Strategy: Analysis and Practice Slide 1/15 ©The McGraw-Hill Companies, 2005 Risk Indices (continued) Limitations: Very broad categories difficult to tailor for individual decisions. Investment decisions also depend on particular characteristics and needs of the investor. Competition may be intense in attractive countries. Assumes the past is a guide to the future.

Strategy: Analysis and Practice Slide 1/16 ©The McGraw-Hill Companies, 2005 Scenario Planning Identify the focal issue. Specify the scope of planning and its time frame. Establish the broad background. Identify the driving forces that link the focal issue with the long-term future. Identify critical uncertainties in the environment.

Strategy: Analysis and Practice Slide 1/17 ©The McGraw-Hill Companies, 2005 Scenario Planning (continued) Combine the driving forces with uncertainties to create alternative futures. Validate the alternative futures. Analyse the scenarios for similarities, differences, sources of difference, mutual dependence. Quantify the effect of each scenario on the firm and formulate strategies. Develop strategy options and criteria for future choices and paths.

Strategy: Analysis and Practice Slide 1/18 ©The McGraw-Hill Companies, 2005 Concluding Remarks All organizations and managers face uncertainties and risk. Risk taking relates to the risk taker’s changing fortunes. Organisational risk is increased by complex and dynamic environments and resources scarcity. Managerial risk is increased by high aspirations, heterogeneous leadership, direct ownership and slack.

Strategy: Analysis and Practice Slide 1/19 ©The McGraw-Hill Companies, 2005 Concluding Remarks (continued) Risk management techniques tend to be short term and can produce a false sense of precision. Scenario analysis is longer term and explicitly addresses the need to prepare for a range of possibilities.