IB Finance and Investment - Assignment Example

1. Systematic risks and unsystematic risks Bobby Blair has suggested that he has considered the systematic risks and also the unsystematic risks in his study. The systematic risks are regarding the replacement of assets after they have served useful lives, product continuance and development of new products. But, apparently, he does not seen to have considered the unsystematic risks which impinge the future of Success Inc. in terms of the future availability of raw materials for products, the economic heath of the country, conspicuous fluctuations in interest rates, entry of new competitors, and changes in the local labor markets that could affect his business prospects. These are significant factors and need to be considered while drafting a green paper on capital budgeting. According to the writer, it makes a significant difference that the entire stock is held in toto by Blair’s family; since it implies that there are no outside shareholdings that could interfere with corporate decision making and execution of capital projects. There are no outside stakeholders who need to be convinced about the viability of investments or its financial implications on the company. However, the risks and responsibilities for investment decisions are to be to be taken by the Blairs and they are answerable for these options. It has been said that the Blairs do not have a well-diversified portfolio of investments and all their wealth has been parked in Success Inc. Hence the success of this Company is vital not only for the company itself, but also for its owners and total stakeholders. However, if major projects are to be undertaken in future it would become necessary to broaden the capital base by public equities or debt capital, for long term sustenance in the fiercely competitive market. In business, the more judicious and market oriented risks that a Company takes, the more return accrues to them, since risk is tantamount to returns. However, having adopted a conservative approach, it needs to be seen that the Blairs undertake recycling of internal funds by increasing their retained earnings of $ 3760 in the years to come, in order to strengthen the bottom line of the business. 2. Calculation of the return on equity using the risk premium approach The total liabilities of the Company excluding accounts payable and accruals works out to $ 8256. Applying this weight age on the different types of liabilities, it works out as follows: 1. Notes : 824/ 8256 = 0.099 2. Term loans : 2372/8256 = 0.287 3. Owners equity : 1300/8256= 0.157 Next, the after tax required returns on the deposits work out to: 1. Yield on long term govt. Bonds = 0.075 (1-0.30) = 0.525 2. Yield on company bonds = 0.090(1-0.30) = 0.063 3. Yield on short term deposits = 0.080(1-0.30) = 0.056 Therefore the rate of return would be as follows Rate of return = (0.099) (0.5252) + (0.287)(0.063) + (0.157)(0.056) Or rate of return = 0.0519 + 0.018 +0.008 = 7.79 or say 8% Rate of return = 8% after rounding off 3(a) not attempted 3. (b) Determination of Risk adjusted discount (Hurdle rate) This is done by adding the aspect of least risk (Government) Bonds return rate =7.5% with the Risk Class In the case of Success Inc. it is as follows Risk Class Discount rate (least risk Govt. bonds adj. for risk factor) A 7.5 + 0.6 = 8.1% B 7.5 + 1.0 =8.5% C 7.5 +1.8 = 9.3% 4. The most important step in developing risk premium for various risk classes lies in the fact that we have to consider the present value of the future risks and its quantification. Besides, a lot of economic factors would impinge on the different risk classes that need to be quantified. Since the risk premium is the additional amount the investors would demand for investing, it goes naturally that the important aspect, is the risk assessment and evaluation. However this is earlier said than done. Risk assessment is an entire gamut that even involves actuarial valuation, the probability or non-probability of occurrence or non-occurrences of events. Since the future is uncertain, it can be only determined through approximations and close estimates which may change due to supervening factors. There are both controllable and uncontrollable factors in business, and thus the evaluation of controllable variances could be better analyzed and evaluated, when compared to uncontrollable factors. In the case of capital budgeting, it is important that the total implications of the plans are made with all relevant data and are considered after weighing all the alternatives available. 5. The top two categories deal with the average risks in that they relate to the routine replacement of equipment after useful life whose book value would have reduced considerably and the continuation of existing products with well established market areas. Bobby Brown propounded that the standard operating procedures using the worst case should be adopted and also the projects should pass the two tests of, firstly, the Internal rate of returns should not exceed risk adjusted required returns and secondly, the estimated losses in the worst cases should not exceed 20% of the project cost. Coming to the first aspect, the writer feels that the worst case analysis should be used with the best case under which the machineries would be available at economical rates and favored pricing. In a worst case scenario, it is seen that there are shortages of the items and are available at relatively high prices and therefore there are chances of the project aborting or getting cancelled. In such cases the worst case analysis, would help management to know the maximum losses that it would suffer, and there by taken necessary pre-emptive precautions either to avoid the contract or take steps to circumvent it by other methods. In the first case it is seen that it relates to the replacement of aged equipments who have served their lifetime, and it is but natural that they need to be replaced at current costs. In such cases, it is necessary to find out the present value of future investments on replacement of assets, the internal rate of returns figures out the discount rate that equalizes the present value of the project’s expected cash inflows with the present value of the project costs. Therefore what is meant is that the IRR =< required returns. It is not always possible to accurately determine the value of asset acquisitions since factors like depreciation, residual value, lease or purchase factors may be present. Therefore, it is felt that the worst analysis theory and the best case should both be used for assets replacements. It is further said that, in the worst case, the value of losses in such project should be restricted to 20% of the project costs. By putting an upper cap for capital budgeting, especially in a low risk venture, with worst case scenario, it also needs to be sensitive to the variability aspects. The scenario analysis provide the depiction of the maximum and minimum benefits (losses) that may occur to the project considering all its variable and therefore the management is well aware of the maximum consequences of wrong decision making. Next, coming to the worst case scenario of the established products with well entrenched market areas, the variables are that the IRR should be equal to or lower than the rate of returns, and the loss of the project should be not more than 20% of total project costs. In such a scenario, it needs to be seen whether a project could result in low product wise sales, lowered selling prices and higher overheads. In such cases the maximum losses need to be ascertained, restricted to 20% of the project costs. it is seen that by using the worst scenario, he is able to assess the maximum losses that could occur to the company by accepting such projects. This is crucial for managerial decision making in that once he is aware of the parameters of best and worst scenarios it is possible to chalk out development activities accordingly. 6. The hurdle rate refers to the rate of minimum risks after considering all the risk factors. In the case of Success Inc. it is seen that there has not been any scientific basis or analysis of the intricacies of capital budgeting because the owners were engaged in consolidation of markets and improving marketability of their products. But now that the scenario has changes and the Company is well on the road to growth and development it has become necessary to resort to knowing, before hand the economic and financial predictions that drive business along the safe and profitable routes. In this case study it is seen that the risk assessment and computation of market risks associated with major projects were not done leading to the comments made by Mr. Bobby Brown. The different methods of capital budgeting are through the application of management tools like calculation of NPV, the knowledge about the use of payback period, Internal rate of return, profitability index etc. Through the use of these tools it is possible to management to predetermine the profitability or otherwise of its potential projects, and thereby able to exercise choice of the best alternatives available, as far as the choice of the most profitable projects are concerned. Further, through the use of capital budgeting, it is possible for management to calculate the present value of future investments and planned programmes. Coming to the hurdle rate, by assigning a single hurdle rate the element of risks involved are not correctly pictured. Different projects have different risks, and even the same project may experience higher elements of risks, especially at the early stages. By following a standard risk rate, it would be difficult to gauge the risks associated with alternative proposals and which ones are to be accepted and which ones to be rejected. In the case presented earlier, it is seen that the hurdle rate for the three classes of risks, is different at 8.1% for Class Risk A, 8.5% for Class Risk B and 9.3% for Class Risk C. Therefore, it is seen that different hurdles have been assigned to different classes of risks thereby it is possible to get a correct estimation of the risks involved and the decisions to be taken accordingly. In other words, the cost of the capital is the hurdle risk which is present in order to evaluate the risks present in the various investment options available to the company. Since different Investments options have different levels of attendant risks, it is but natural that the hurdle should also be different for correct comparisons and analysis methods. 7. Risk Evaluation in capital budgeting: There are several aspects to be dealt with regarding the risk evaluation. As mentioned earlier, risk evaluation differs with type of investments and the quantum and nature of investments. Capital budgeting may be required for the following reasons’ For replacement of assets upon end of useful life For replacement of assets for cost reduction or efficiency enhancement For expansion of existing markets moving to global markets or new areas of business diversification Investments made for complying with local norms and rules For meeting research and development needs of the business to maintain competitive advantages. R & D. investments Future Cash flows made for long term or special contractual agreements It is proposed to evaluate the risks in each of the above cases for further study. Replacement of assets upon end of useful life : the risk evaluation with this is regarding the different options regarding the proposed investments, their capital outlays, the useful lives of the proposed assets, its depreciated values and the final values upon dismantling of the asset after the life is completed. Aspects such as repairs and maintenance and residual values are also contributory factors for the asset replacements. The risk assessment is required because it may happen that the asset may become malfunctioned or inoperative during its lifespan, in which case the investments come to naught. For replacement of assets for cost reduction or efficiency enhancement Due to the advent of newer technology it is possible to replace existing machineries with new ones for cost savings and added efficiencies. The risk involved is whether these investments are worthwhile and would serve the purposes for which it is intended. It also needs to take into consideration other alternatives available along wit their financial evaluations For expansion of existing markets: Sometimes the present markets may have become saturated or very competitive, resulting in lowered turnover. In such cases it may be necessary for the company to seek fresh markets within the region or in other parts of the country. A comparative risk assessment of investments in other parts of the country with respect to projected levels of sales, costs and competition needs also to be undertaken. Moving into global markets: As a part of globalization the company may make forays into the international sectors and market segments in order to gain international Exposures. In such cases, the attendant risks of the global environment needs to be considered and the projections regarding the proposed investments Investment in safety devices: it is seen that in order to comply with health and safety norms, including statutory norms. certain investments need to be made. In this regard, it is seen that comparative investment proposals including their discounted values may be made for the project appraisals and investment decisions. For research and development purposes : In a competitive market like Success Inc. it is seen that research and innovation is necessary in order to remain competitive and afford increased value for stakeholders and at the same time, also make value additions to products and services. R & D has assumed special significance in recent years especially in the fields of software development, which are now being increasing seen as investment costs and not expenditures. However, the scope and utility of R&D and its significance in the context of the company’s operations need to be correctly evaluated and also, correct evaluations of the quantum and nature of the investments also needs to be made. Thus it is possible to make correct use of the research and development costs in order to further the business development of the business in the context of rising competition and availability of alternative products. Another aspect of R & D in the context of risk evaluation lies in the fact that software technology is fast changing in the global business environment and therefore, the company must be in a correct position to judge the need for investments in this area and also the benefits and risks that accrue because of the Research and development programmes in the business. Special contracts and long term agreements: It may sometimes happen that the company may be predisposed with special orders for say 4 – 5years currency , and therefore it becomes necessary to undertake financial studies to evaluate the financial viability and suitability of accepting the contracts, especially in an inflationary climate where the costs of raw materials and other essential inputs are rising globally and there are possibility of costs overruns. In such cases it is necessary to make sound financial decisions using the Capital budgeting concepts. This is also important because there are chances that the contracts may terminate midway as major contracts may happen, due to political or other reasons. In such cases, it is necessary to utilize capital budgeting in order to create worst case scenarios to determine the maximum losses that could accrue. All theses could be facilitated by the risk assessment of Capital budgeting Conclusion: It may be said that Success Inc is by and large a growing concern, family owned and needs to consolidate its position in the market place before taking up major projects involving heavy capital investment. In such cases, it would be better to resort to the capital budgeting practices in terms of choosing the most profitable investment projects, in order to enhanced the company’s share value and also provide ample reserves for the future development and growth of the concern, Mr. Brown may utilize maximum benefit from the correct application of the theories and practices of Capital budgeting in order to provide the best financial decision making and investment choosing techniques available to him by risk assessment of various projects and its implementation in the company. Read More