Corporate Risk Management - Essay Example

a) What are the real-world components of Ct, I and k for evaluating the following types of risk management activities at NPV? i) Risk retention ii) Risk transfer iii) Risk control, and iv) Risk avoidance Answer: 1) Risk Retention: Risk retention is a form of Risk management strategy wherein the organization determines that the cost of transferring risk to outside entities and third parties is greater than retaining the risk of loss and offsetting it through their own emergency funds and allowances. In a nutshell, risk retention is a strategy that recognizes the firms profit in managing the eventuality of loss on their own rather than managing it through insurance or offsetting it to third parties. Components that affect Risk retention activities: Quantum of Investment: Apart from the usual financial decisions, it is vital that the firm looks at how much investment it is making into a particular project. If the quantum of investment is significant and depending on the size of the firm, sizeable enough to affect future earnings in a way that negatively affects the firm, then it is more preferable to go for risk transfer. Conversely, if the investment is not of a quantum that can affect the firm negatively it is better to go for risk retention. 2) Risk Transfer: Risk transfer, also known as Risk sharing is in many ways the complete opposite strategy of Risk retention. The principle of Risk transfer is the underlying tenet behind most insurance transactions. Risk transfer generally involves the shifting of risk to another party, most usually by means of insurance or through warranty. This method assumes the longevity of the third party and the ability of the insurer to maintain business continuity. Components that affect Risk Transfer Decisions: Cash Flow Regularity: One of the biggest risks associated with investment decisions, particularly in light of whether or not to transfer risk or not, or to whether just bear with the uncertainty is how regular or irregular the earnings of that particular investment decision are. It follows then that the more irregular or uncertain the earnings of a particular investment decision are, the more likely a firm is to increase its security or safety in regards to that investment or that line of cash flows. Hence, the greater irregularity is seen in cash flows, or the higher risk factor involved, the more likely a firm is to transfer risk either via Insurance or Warranty. 3) Risk Avoidance: Risk avoidance, on the spectrum of Risk management activities is on one end of the spectrum, wherein the company decides to altogether excuse itself from all possibility of risk. Although this strategy is often considered the safest form of risk management it also entails the loss of any potential revenue that could have been gained from the investment, therefore while it is the safest strategy it isn’t the most practical. It is also misleading as avoiding all risk is not always possible and it is only applied in the contexts of particular cases. Components that affect Risk avoidance decisions: There are several real world factors while considering the strategy of risk avoidance in relation to a business or financial decision. The most common and compelling factor while deciding to avoid risk altogether is the ratio of risk to reward or the investment earning ratio. As such, the two factors of income and investment are seen in relation to one another while making a decision in regards to this strategy of risk management. Another component that factors heavily in regards to this decision is the discount rate and whether or not it conforms to the expectations of the organization in relation to the project. Other factors that weigh in on decisions like this are: the organizations strategic goals, long term effectiveness of projects like these, feasibility of project specific details, time period involved in regards to income and earnings as well as the total NPV weightage. 4) Risk Control: This is by far the most popular and widely used technique of risk management. This strategy involves actual managing the risk, taking positive and proactive steps to minimize the impact of identified risks wherever possible and putting in place certain rules, procedures and steps that minimize the risk of loss as well as the magnitude and severity of the loss. It is the most widely used strategy as it allows for the carrying forward of various activities and operations with the best possible preparations while at the same time minimizing risk from various source. Risk control is basically calculated, informed risk taking occurring whenever investment or financial decisions are undertaken by an organization. Components that affect Risk Control decisions: As in regards to Risk avoidance there are also various factors which contribute towards the decisions in regards to risk control, all of these have a significant impact on how and when to implement the necessary procedures and steps needed for calculated risk taking such as: Identifying potential risks and pitfalls in relation to steady income streams. If the risks to the investment are too great or if the time period for incurring gains is too haphazard then it is possibly better to avoid risking investment in the project and instead go for some other form of risk management strategy. Secondly, not only the regularity of the net income but in what way it aligns with the overall visions and strategies of the organization also comes into play when deciding on risk control strategy. Risk control requires perhaps the most comprehensive and complete understanding of the various components of net income, discount rate, investment and time periods than any other strategy of risk management. Provide practical suggestions for estimating realistic values for the variables identified in part a) of the question. 1) Estimating Net Cash flow: Technically speaking Net Cash flow is defined as simply the difference between a company’s total cash inflow and outflow during a given period of time. It refers to the change in a company’s balance of cash as reflected in its cash flow statements. It is the fuel that powers the growth and progress of a company. Net cash flow is what ultimately allows companies to conduct their day to day business, it is considered by some to be a better indicator of a company’s performance than almost any other financial measure. Suggestions for accurate measurement: The cash flow of a particular period may be approximated by simply looking at the statements of cash balance in the technical documents of a company such as the balance sheet, however a far more important tool for measuring net cash flow is the statement of cash flows which shows the different cash inflows from various sources. This method, however is not always feasible as cash flow statements do not always reflect the most accurate reflections of cash inflow. A much better measure of Net cash flow may be to simply rely on finding out the cash inflows from operating activities of the investment or the project as these make up the majority of cash inflows when dealing with company investments and projects. This includes any type of cash inflows generated during the course of day to day operating activities. Although this kind of calculation may be difficult when it comes to long term investments, the best approximation of operational profits and cash inflows should be used to generate a figure for cash inflows. Following this a general outlook in regards to the cash outflows of the investment should be generated. Infrastructural costs, setup costs, day to day activities that result in cash outflows, variable and invariable costs both should be estimated according to realistic and up to date estimations and not just according to what is shown on the balance sheet. As such it is an excellent idea to get the inputs from the ground level, from the factory floor and not just the accounting department. A simple difference between the two forms of cash flow would give a pretty good understanding of the net cash flows expected from a particular investment or opportunity but the key here is to take into account the cash flows that result from the operational activities of a particular investment as those reflect the most accurate net cash flow situation. 2) Estimating Discount rate: Discount rates in regards to Net cash flows are an estimation of what those future cash flows would be worth in terms of present value. This is a rate that discounts the cash flow predicted from a particular investment so that the accurate value of the cash flow in terms of its value today is shown to the closest degree of accuracy. This step is usually taken after estimating the cash flows for a particular investment to see what the value of those cash flows is in contemporary terms. Suggestions for accurate measurement: There are a wide variety of methods for accurately measuring the discount rate for a particular investment or cash flow. However, most of these methods are generally very open ended, open to interpretation and based more on the analyst’s own subjective views rather than on a precise implementation of formulae. Therefore the first and foremost point when estimating discount rates is to use a thorough and rigorous method to do so since it is better to be generally correct rather than precisely wrong. It is a very good idea to look at a blend of the cost of equity as well as the cost of debt that is going into financing the investment, the weighted average cost of capital is an excellent method which analyses both of these components in good detail. Factors in cost of equity: Although there is no set price when talking about cost of equity, it is also wrong to assume that there is no price at all when it comes to talking about equity. The expectation of equity shareholders that they will receive an equitable return on their investment is a major factor in whether or not a company will be able to raise the necessary equity or not, this is a major cost to calculate when looking at raising funds through equity. A company should look long and hard at what the expectations of their investors is and how to best fulfill them. Factors in Cost of Debt: The cost of debt is perhaps the most straightforward cost to calculate while deciding on the calculation of the discount rate. It is simply the current market rate at which the company is paying for its debt. However for an accurate picture of the true cost of debt it is preferable that the deductions and benefits accrued from the interest paid on debt be deducted, so it is much more accurate to take the after tax cost of debt as the true cost of debt. The two factors outlined above provide a fair picture of the capital structure of an organization which helps better determine the discount rate at which the investments of the organization should be valued at. 3) Estimating Time periods: The time period is assumed to be how far into the future the company can expect cash flows from their investment. For the purposes of a company the time period involved with an investment is the time for which the company earns returns on its investment that are greater than its cost of capital. It tells us how far into the future a company should plan on receiving positive cash flows. However, such an estimation is impossible to make with accuracy and the best that a company can do is make an educated guess. One of the best methods of determining an approximate time period is to analyze the company’s competitive position as well as the prevailing market conditions at the time of investment. As a general rule a slow moving company or a company that is just starting out should look at estimated time periods of one year or less, medium sized companies achieving at par growth should look to invest in projects with a time period of up to five years and companies with excellent growth should estimate time periods of ten years or more. References: S. E . Harrington and G. R. Niehaus, Risk Management and Insurance, 2nd ed. McGraw Hill International, 2004 (HN) C.A. Williams Jr., M.L.Smith and P.C. Young, Risk Management and Insurance, 8th. ed., McGraw Hill, 1998. (WSY Read More