Risk Measurement and Management - Assignment Example

Managerial Finance Part Questions Question Shareholders are those individuals that own the company’s equity sharesin terms of the total capital gains and dividends per specified risk level. The assumptions and objectives of the shareholder on wealth maximization model include that a given company’s objective should be to maximize shareholders’ wealth. This directly means that the management should endeavour to maximize the shareholders’ return. Every given return on capital should be achieved by carefully looking to minimize any risk that is posed to the owners of the equity. Increasing or lowering hurdle rate will only work to influence the way managers will set their management plan to achieve or meet only the set hurdle. Any effort that could increase profits above the hurdle will be ignored since the manager after meeting such pre-set goals will relax. Again, setting hurdles will also work against the regional executives since different policies affect investments differently according to the given country. Each country has a different inflationary level, lending rate, political stability and other cultures which together or singly affects investments. Setting a uniform hurdle rate is being unfair to countries with unfavourable investment policies. Question Two. 2 Investing in Lower risk projects will normally be a favourite of the lower division managers since chances of them losing out on the investment is limited. This however, will always come with unfavourably low or unattractive incomes. While this might appear favourable to the managers, it may turn out to be a dislike of the shareholders. Shareholders would want to maximize profits without regards to risks involved, while the managers are more concerned about the risks involved in each venture. Risk is may be defined as the standard difference of return on an investment or portfolio of assets. It is measured using different methods including Value at risk. It helps business men to get prepared for the potentially turbulent market and is quoted in terms of percentage and fixed time horizon (Kwon Joon Chang, 2008). Example; If a 77% one day of value at risk, and the security of 6%. This means that the estimate for the example is that in the next one day, there is 77% chance that the security will not lose more than 6% of its value. The equation may be written as: VaRα = inf{x ϵ R: P (L > x) ≤ 1 – α} It has the advantage of being able to work all the time. It is based on normal distribution to make it easy for calculation. Disadvantages It does not take into account the downside potential in case the portfolio encounters the one percent chance that it exceeds the loss threshold. In other words, once the losses exceed the threshold, one can’t tell the size of the loss. It creates a false feeling of the loss tolerance allowance instead of discouraging incurring losses at all cost. It also works under the assumption that the asset returns are normally distributed which obviously is inconsistent with normal empirical data. Sensitivity Analysis Also one of the preferred technique of risk analysis by measuring how net present value (NPV) of a given investment decision may change in response to a given change in an input variable assuming other factors remains constant. In actual sense, this technique asks what if questions about the investment and the effect on the corporations. Input variable change leads to a calculation of a new NPV which is then plotted against the changed variable in a graph. The bigger the gradient, the more sensitive the NPV is to change in the variable. Question Three Additional political and economic risks that MMI faces in other countries can be factored in by devising proper risk management strategies that is specific to each country. No risk management strategy can be applied universally to all the internationals since even if the risks were to be the same, they will not have the same magnitude. However, insuring the project against the highly anticipated risk will help buffer the company in case the unforeseen happens (Matthee, 2011). Political risks may be handled by trying to understand the foreign investment policies of the said country as well as the effects of taxation. Different countries tax foreign companies differently and for this reason, MMI should attempt to understand the foreign investment policies of the given country through the undersigned bodies which for USA would be Committee on Foreign Investment in the United States. (CFIUS) (Kobrin, 1979; Clark, 1997). Economic risks A better method should be one that takes care of quantification of risk on the basis of monetary value, effects of macro economy, encourage diversification and is sensitive to small as well as large losses (Kwon Joon Chang, 2008). The projects of extremes of risk and return are not reaching the top management is as a result the executives fearing that high risk projects may perform poorly thereby making them fear for their jobs. On the other hand, low risk projects are not favoured by the top managements thereby not being a favourite. These executives argue that so long as they meet the hurdle set by the top executives, they are ok since it’s the same was set by top executives who set the same. Actually, this may be the causal factor. Mr Black should therefore remove the strategy of setting hurdles for the divisional managers and embrace a policy of understanding and rewarding the best performer. This will encourage the managers to work beyond the hurdles to be the best. Part II: Equity Funds vs. Loans from MMI Question 1 Equity funding will be preferable because the company will not have to repay the financing back to the owners. It also allows the company to share the risk with the new financiers since they will also be sharing the ownership of the company. It however, has the problem of having to give up some parts of the ownership to other people and thereby losing on the control. By control, it mean decision making authority. In long term, distribution of profits to these other owners may surpass the cost that would have been incurred to repay the loan. It also has the problem of being taxed and therefore for a company wanting to minimise cost, this may not be appropriate. This method however is expensive in the long run but cheap in the short run compared to loan from MMI (Jennings, 2015). Loans from MMI is advantageous in cases where the company wants to spread the cost for some period. This method is not favourable in a country with unstable inflationary levels. For this reason, high inflation levels may result into a loss to MMI since the rate will have to be revised upwards something that will be contentious. The other disadvantage is that it will have to be repaid plus interest. However, this source of financing is favourable because it allows the company to be exempt the financing from paying taxes on it. It also allows the company to spread the cost over a period. This method is expensive in both the short and long run (Kabbage, 2015). Question 2 Normally International or multinationals will choose a given financing method after considering different aspects related to costs in both the short and long run. However, the debt financing of more than 35% will be favoured if in cases where the total cost of the finance will be cheaper in the long run. Most countries exempt corporations from paying taxes on the interest being paid (Yasuhiro Yonezawa, 2006). Unlike, equity financing which is subject to non-resident withholding tax in the subsidiary country, interest on debt financing is exempted from taxes and thus may be a cheaper source. In general, leverage is affected by taxation of dividends as opposed to debt (Gilbert, 1998). Higher debt financing of more than 35% is appropriate for countries that don’t tax the interest while a smaller of less than 35% is appropriate when the policies are not favourable as compared to the alternative like equity financing. More than 35% is also applicable when the inflation rate is not higher and can be estimated and vice versa is true for less than 35% (M. A. Desai, 2004). Question 3 More debt financing will amount to less income available to the shareholders since they will be repaying the loan with the most part of revenue generated from the project. However, equity financing will be just additional source of funding that will not be repaid in terms of repayment but inform of dividends which can still be ploughed back into the business. For this reason, debt financing lowers rates of return on affiliate projects and equity financing will increase rate of return on the capital. Due to different economic status in different affiliate countries and due to different investment conditions, MMI’s dividend policy should be implemented differently within these countries. This should follow things like the taxation policy of the affiliate country on the withholding dividends as well as nature of financing that dominated the affiliate company. Bibliography Clark, E., 1997. Valuing political risk. Journal of international Money and finance, pp. 484-486. Gilbert, H., 1998. Taxes and division of foreign operating among royalties, interests, dividends, and retained earnings. Journal of Public Economics, pp. 269-290. Jennings, R., 2015. Sources of finance and their advantages and disadvantages. [Online] Available at: http://smallbusiness.chron.com/sources-finance-advantages-disadvantages-14407.html [Accessed 21st June 2015]. Kabbage, 2015. Working capital loans-the advantages and disadvantages. [Online] Available at: https://www.kabbage.com/blog/working-capital-loans-the-advantages-and-disadvantages/ [Accessed 21st June 2015]. Kobrin, S. J., 1979. Political Risk: A review and reconsideration. Journal of international business studies, pp. 67-80. Kwon Joon Chang, C. L. T. Z., 2008. Risk Measurement and management: An indepth look at how Wall street professionals deal with market risks. p. 23. M. A. Desai, C. F. F. J. R. H., 2004. A multinational perspective on capital structure choice and internal capital markets. Journal of Finance. Matthee, H., 2011. Political risk analyis. CA: SAGE Publications. Yasuhiro Yonezawa, H. Y. T. Y. T. N., 2006. capital Structure choice of the foreign affiliates ofJapanese Multinational firms: Characteristics and Problems. Japan Center for Economic Research. Read More