Risk and its Importance - Coursework Example

Risk and its Importance 1. The Role of Risk: a) Risk and its importance in the investment appraisal process Risk, in pretty basic terms relates to someone or something that can create a potential hazard in the future. Risk is basically a probability of things going towards the worst side of the outcome paradigm. The probability of things not going the way as planned is present in almost every walk of life. In business decisions, the importance of understanding risk increases three folds due to the money that is involved and the stakes of the decision (McLaney, 2007). Essentially a company is indulging into risk management if it is actively analyzing and attempting to quantify the possible losses in a business decision or an investment and then is taking appropriate action to mitigate the possibility of those losses occurring. It is fairly important to manage risk in an investment appraisal process as it helps the organization in protecting itself from all kinds of risks; it helps the organization’s customers from large non-market related losses such as a firm failure or fraud. A strong risk management process does not only help the organization, but it also provides security to the overall industry. Importance of risk management can also be gauged by some recent crisis that has happened due to loopholes present in risk management strategies of a few companies. The financial meltdown of 2008 is a key example. b) Measuring risk and incorporating risk in an investment opportunity Risk management is now an essential part in all the businesses as more and more businessmen are facing the repercussions of a poorly managed business decision in terms of risk. With the financial crisis slowly recovering, it is harder for people to now ignore the importance of risk. Predominantly, risk is considered to be a negative term. It is the probability of a result deviating from its forecast, usually towards the negative side. Therefore, it is predominantly considered negative. However, in investment and financial terms, risk is always associated with return. The more risk a person or an entity is willing to take, the more the return is expected. Understanding risk today is perhaps one of the most important things in financial education and financial market. Its importance cannot be stressed more. A deviation from expected outcome can both be negative as well as positive. Therefore, the idea of ‘no pain, no gain’ works in harmony with this situation. If one is willing to undertake a certain amount of losses to ensure that they are the winner in the end in terms of returns, they are effectively managing their risk. Measuring risk in absolute terms is done through standard deviation. It is the basic tool for understanding the deviation of an outcome from a central tendency. A lot of other techniques are used; tools are incorporated in order to measure risk of an investment opportunity. There are a number of models through which firms decide upon the nature of risk that an investment opportunity might have. VaR is another tool; value at risk defines how bad things can go and its probability giving a certain level of confidence for a given amount of time. This helps to identify the potential losses that an investing entity might have if they take a certain decision, taking time and confidence of calculations into account. Incorporating risk in an investment opportunity is through taking into account the impact of risk on the outcome of the investment. Critical questions should be answered as the start of the investment appraisal such as the time, the expected return on investment or if the money invested could be used better in another investment opportunity. Beta is another measure through which risk associated with two different investment opportunities is measured. It is specific for a specific kind of project (Jackson, 2008). c) Environmental, social and other non-financial factors that affect the appraisal of an investment opportunity. Quantify them Investment appraisal is done through a number of approaches. These approaches may be basic but are fundamental in understanding the basic undertaking of risk in investment opportunities. Future cash flow is an important thing in understanding the risk of an investment. If the probability of future cash flow is primarily good and one can recover basic costs soon then it is a good investment. Net present value (NPV) is another method for risk appraisal and it is considered as one of the most reliable methods of measuring risk in an investment. Payback period is the method through which the basic investment recovery is gauged. Internal rate of return measures the return in relative terms and therefore, helps in identifying a better opportunity when two are under consideration. Factors affecting the appraisal of an investment opportunity are basically divided into two broad categories. These are the qualitative factors and the quantitative factors. The factors that can be quantified are added to tools used in investment appraisal and hence are called quantitative factors. Investment appraisal is done through a number of tools that use rate of return and initial investment to the project into consideration. Payback period is a tool used to determine the time it will take to recover initial investment. Net present value uses discounted future cash flows to understand the net result of the cash inflows and outflows from the project. If it is positive, as a rule of thumb, the investment is considered a good investment. Quantitative factors provide a strong numerical basis for the decision making process. It helps decision makers make the decision by looking at a monetary value placed at different choices they have available. A very important factor is forecasting as most of the models used to gauge the financial viability of a decision require forecasting of the inflows and outflows. However, these factors only provide one part of the story. They are the non financial factors that are harder to be quantified. A number of tools are used to understand these qualitative factors. Qualitative factors take into account other issues that may influence the outcome of a decision. The impact of these qualitative factors can be wide ranging and especially need to consider the impact on human resources and their response to decisions. Environment plays an important role in the success or failure of a decision. It can impact the business decision in such a way that no financial models can predict. SWOT is an analysis that takes into account the internal factors as well as the external factors pertaining to a business decision. It discusses the strength, the weaknesses, the opportunities and threats that an organization faces that might impact the business decision the company wants to make. PEST takes a broader picture in mind; it takes into account the political, economic, social and technological factors into account for a business decision. For example, the decision to place a number of wind turbines in a coastal area might be justified financially but the reaction of the local community, the government policy related to this matter and any social impacts such as pollution, waste can have a harmful effect on the overall well being of the project. These factors can make or break the situation. Quantifying qualitative factors is the best way to include their impact in a financial decision. A wide range of tools are used for this purpose; matrix ranking, resource mapping, causal analysis and diagrams are used to quantify and predict the impact of these qualitative factors (Peter, 2009). 1. Using cost behaviour predictions in decision making: a) Explain various types of costs and their benefits Costs are probably one of the trickiest parts of a business. There are so many classifications and financial accountability for these costs with most of them overlapping each other. There are so many ways through which costs classifications are done. For cost behaviour related to business activity, there are fixed costs and variable costs. Fixed costs are that part of the total costs that an organization has to incur even if they do not make a single product. Costs such as payments of rent of the building or the office cannot be avoided even if the company does no business at all. Payments to the sales departments will have to be made even if they are unable to make the desired number of sales for this year. A variable cost on the other hand depends upon the level of output. The more the output the more variable costs will be there. For example, the cost of labour used in making the product will increase. If five people work on one product, the more products that are made the more people will be needed to work on them and hence the labour costs will increase. Similarly the raw materials that go into the product also increase if higher levels of products are made. Therefore, variable costs increase with increase in the level of production. Fixed costs, on the other hand remain the same. Therefore, in order to break even, for an organization, it is important that they can at least cover their fixed costs. There is another way to classify costs. It is on the basis of function. The best example would be the costs related to administrative department and the sales departments, the finance department; they are costs based by the function of the organization. They can either be product related costs or period related costs. Period related costs are easier to understand. They are the costs that a function incurs in a given time period. For example the costs incurred by marketing department to market the product for the whole year are period costs. On the other hand, product costs are the actual cost of products that went into making the product. This includes raw materials, labour costs and manufacturing overhead. Both of these costs are treated differently on the accounting side; product costs are accumulated under cost of goods sold while period costs go into the income statement as they were incurred while generating income. The benefit of classification of these costs is traceability; it increases the accountability of the costs that are incurred so that all the money spent can be allocated accordingly. As mentioned above, this different type of costs are treated differently in financial statements, therefore, to know and understand these costs are very important (Ray, 2009). b) Explain to the board of directors why the classification of costs previously discussed is not always right. Accounting classifications in cost accounting has had many advantages due to which it has been highly successful and is being used all over the world today. It allows for traceability of the costs that incur periodically as well as product wise. But there can be a visible discretionary side to this classification of accounting. Two individuals can access the same situation in two different ways and can lead to a different outcome for cost allocation. Human minds can function in two different ways and the humanity is accounting should be given tremendous importance. Since two people think differently about two things, they can end up determining different costs per unit. Since there is bound to be overlapping over the different types of costs that are associated to a product, it is on the discretion of the accountant to add them to their respective cost pools so as to increase or decrease its impact on the financial statements. This, more prominently is known as window dressing or manipulation of accounting statements to favour the organization. The majority of accounting for the future is done through forecasting. Estimation is based on reports, guidance of market surveys and indices etc. Cost estimations for the future will have an estimate of inflation as well, leading to inaccuracies for the future if the inflation rate is higher or lower than the estimated. Accountants can only estimate the current cost of the asset and this leads to another problem of discretion as different people will have different opinions about current costs. In cost accounting, most of the costs are based on estimation and conventions and don’t necessarily mean they are completely accurate. When it comes to indirect costs, they are charged on the basis of estimations. Also, in activity based accounting the idea of assigning indirect costs to products is done on estimation or the level of activity, bringing in doubts about the accuracy (Peter, 2009). When it comes to decision making, the board needs to take into account the sunk costs that actually are accounted for in cost accounting however, should not be considered in the actual decision making. An integral part of decision making is to understand the difference between sunk costs and the actual costs. BIBLIOGRAPHY Atrill, P. & McLaney E. (2009) Management Accounting for Decision Makers (6th edition) Financial Times Publishing London Proctor,R . (2008) Managerial Accounting for Business Decisions (3rd edition) Financial Times publishing London Jackson, S., Sawyers, R & Jenkins, J. (2008) Managerial Accounting, a focus on ethical decision making, 150 -151. Cengage Learning Garrison, R., Noreen, E. & Brewer, P. (2009) Managerial Accounting, Pages 66 - 70. McGrawHill Atrill, P. & McLaney E. (2007) Accounting: An introduction, Pages 35 -42. Financial Times Prentice Hall. Read More