Finance and Growth Strategies - Term Paper Example

 «Finance and Growth Strategies» Introduction Risk management process in finance occupies a very important place and there are efficient ways in managing systematic risk, unsystematic risk and total risk. In addition to calculated moves like the discounting cash flow practices, there are other methods too such as “financial regulatory mechanisms, responsibility in the decision making structure and the chain of command and legitimacy” (Alexander, Dhumale and Eatwell, 2005, p.15). Diversification stands out as one of the most desirable methods to mitigate risk. Regulatory regimes seeking to control financial markets are little too stringent at times though, regulators themselves do not feel that such ‘strictness’ is out of place. Financial stability is sought to be ensured through regulatory measures in the interest of the general public. Yet at times systematic risk grows out of the very regulatory environment. For example the deregulation of former national industries in EU and financial liberalization measures were credited with the slow but sure preventive potential that helped the financial system to head off a lot of critically devastating blows. On the aftermath of the Asian financial crisis countries in the region adopted a series of regulatory measures that were intended to remedy some structural deficiencies in the individual financial systems (Newman, 2000, p.52). Subsequently insurance against failure might be difficult and liquidity problems would crop up. Q. What are systematic risk (systemic risk), unsystematic risk and total risk? Systematic risk is defined as holistic risk affecting the entire portfolio of assets across all segments of the market. In other words risk is more likely to spread through the whole financial system or the market thus causing a total collapse. In fact the ripple effects would be felt beyond the national borders of the country as well. Diversification allows risk to be spread over a number of assets in the portfolio across a number of markets, thus attenuating the risk factor. However there is abatement or mitigation of systematic risk through hedging. Individual investment decisions concerning risk mitigation are inevitably focused on the capital adequacy rules (Jorion, 2007, p.639). Concurrent decisions to mitigate risk and maintain capital adequacy are nothing new in the investment sphere. Sharpe ratio is used to calculate the amount of systematic risk: Here the performance evaluation is based on risk-adjusted measures. Now the question “is the return adequate compensation for the risk?” has to be answered by working out the returns given the risk involved. The following explanations are used to work it out. The Sharpe ratio enables the adjustment of returns on investments to be conclusive with respect to risk-free returns and the degree of volatility of an investment (Temple, 2002, p.166). Rp = Average return on the portfolio Rf = Average risk free rate Sp = Standard deviation of portfolio return (total risk). While Sharpe ratio is useful in determining adjusted risk and performance of a portfolio, there are other measures as well that have to be used in order to determine the level of risk accurately. Treynor ratio: rp = Average return on the portfolio rf = Average risk free rate βp = Beta of portfolio (systematic risk) Treynor ratio is used to measure returns that are in excess of what could have been made on risk-free investment (Jorion, 2007, p.413). For example Treasury Bills are less risky than other volatility-prone assets. That’s why it’s sometimes called reward-to-volatility ratio. It uses systematic risk. Thus higher the Treynor ratio, the higher the returns made on investments. However it is not like Sharpe ratio which is a measure of the excess return and does not help much. Next there is the Jensen’s Alpha, a measure that calculates the excess returns above the security market line as done in the capital asset pricing model (CAPM). CAPM also uses beta as a multiplier to determine the total value of returns (Bradfield, 2007, p.203). Jensen’s Alpha is a risk adjusted portfolio performance metric. It’s calculated by using a regression technique to determine the performance of a given portfolio of a manager tested against a benchmark (Thakor and Boot, 2008, p.213). On the other hand unsystematic (un-systemic) risk refers to a risk inherent in a particular industry or market that falters due to a specifically divergent variable. Unsystematic risk (or residual risk or diversifiable risk) can be overcome by resorting to diversification of one’s portfolio (Baesens, Gestel and Thomas, 2009, p.51). Since unsystematic risk is specific to a particular market or market segment, diversification helps investors either to reduce risk or totally cancel out depending on the relative offsetting effect of less risky investments (Garrett, 2008, 195). For example the internal mismanagement of a company has little relevance to the outside world except to those shareholders and customers of that company. However, it cannot be predicted as to how the subsequent developments would unfold on the whole system. Theoretically such developments would not have a macro-level impact on the system. Unsystematic risk essentially presupposes the existence of a remedial measure without resorting to hedging which can be uncertain for a number of reasons. In the first place hedging is carried out with the intention of obviating systematic risk which occurs as the result of an exogenous variable going astray (Bhattacharya, 1999, p.638). In the case of unsystematic risk exogenous variables are assumed to behave in the predictable way. Fund managers whose instincts the investor relies on, do not feel obliged to advice clients on the contrary decisions. In fact such advice depends not only the instincts of fund managers but also statistical forecasts (Frenkel, Hommel and Rudolf, Editors, 2004, p.459). As the portfolio is more diversified unsystematic risk moves closer to zero. Accounting risk, financial risk and economic risk are all part and parcel of unsystematic risk. They signify the very nature of risk. For instance a financial risk might involve mistakes in cash flow forecasts thus leading to liquidity problems. These residual risks do not have a big impact on the whole system. But nevertheless the degree of this imperviousness is determined by a number of other factors that are inherent to the system itself (Saunders, 1999, p.135). Calculations involve the same process as above. However, CAPM is often used to measure an individual security or a portfolio. Additionally the security market line (SML) is used to measure the reward-to-risk ratio of a security in relation to the total market as shown below (Alexander, 2008, 253). Finally total risk is the sum total of systematic risk and unsystematic risk. While the choice of the individual investor between different types of securities or investment instruments matters here, there is the need for the investor to make some decisive decisions involving which risk out of systematic and unsystematic risks to be reduced vis-à-vis the other (Mangiero, 2005, p.67). The following graph illustrates the hypothetical scenario of a company. the horizontal axis shows the betas of all companies in the market the vertical axis shows the required rates of return, as a percentage Assuming a rate of return minus risk at 5% and further assuming that generally the stock market is going to produce a rate of return equal to 12.5% next year, you see that Utopia Company has a beta of 1.7. We got this result by substituting a few sample betas into the CAPM equation as follows. Ks = Krf + B ( Km - Krf). Security Beta (It’s a measure of risk) Rate of Return 'Risk Free' 0.0 5.00% Overall Stock Market 1.0 12.50% Utopia Company 1.7 17.75% Source: www.teachmefinance.com This figure and hypothetical data can be applied to understand all three types of risks. (b). On Directors’ comments. Directors’ comments are concerned with systematic risk, total risk and the expected rate of return. Assuming that the company is going to hold a portfolio of stocks, the probability is that systematic risk as explained above would be considered by the management on the premise that a sufficiently diversified portfolio of securities such as Treasury Bills, bonds and others would allow the company to minimize risk of failure because at a given time all securities are less likely to exposed to the same degree of risk. Thus only a macro level impact, i.e. systematic risk alone could affect the portfolio negatively as a whole. The second comment, that in order to be cautious the company must consider total risk, implies that there is a fairly good chance for the distribution of risk over a considerable range of the MSL if total risk is taken into consideration. As illustrated above going for high risk securities the company will magnify the beta coefficient related returns, while at the same time investing a certain percentage in low risk government securities which would though not enable it to earn bigger returns (Kumar, 1994, p.31). The third comment is related to a highly technical aspect, i.e. the expected return in relation to the market performance as a whole. Potential investors would necessarily look at the beta range as shown on the horizontal axis of the above graph to determine probable returns in relation to the market performance of a given portfolio of securities. Thus the third director’s comment is relevant for those who look beyond the risk free 5% return despite a higher risk involved (Chong, 2004, p.2). Therefore this comment has more substance than the other too in strategic investment decision making sphere. Overall, these comments are basically incorporated into the investment decision making plans of the company and therefore they are related to the risk perspectives of directors. Their initial decision not to distribute profits among shareholders is necessarily loaded with the idea of generating more returns on new investments. This has a far reaching impact on its performance. Q. 2. (a). Why is it important to discount future cash flows? Future cash flows have to be discounted to obtain their net present value because it helps the company to value a project or an asset by adopting the approach of time-value of money. Thus all future cash flows are discounted to obtain their present values. In the first instance the discount rate which is used to discount future cash flows, would represent the cost of investment capital as approximately as possible (Ryan, 2004, p. 386). The most remarkable feature of it is the factoring in of the degree of uncertainty or risk in future cash flows. For instance the directors’ decision to invest the available money in different financial instruments over the coming months involves a fair amount of risk. Such risk has to be factored in so that future cash flows are discounted with a fair percentage of the probable risk arising from uncertainty. The formula for discounted cash flow is obtained from the formula for future value so that calculations for the time value of money and compounded returns can be made (O’Berry, 2007, p.29). FV= DPV. (1 + ί)n There is also a simpler formula to calculate one cash flow as follows: DPV = FV = FV (1- d)n (1 + ί)n where DPV stands for discounted present value of the future cash flow (FV); FV is the nominal value of a certain amount of cash flow in a future period; i is the interest rate, that shows the cost of having capital in the current form and it also makes up for the probable risk that the repayment might not cover up the full amount; d stands for the discount rate, i/(1+i), i.e. the rate of interest being deducted at the start of the year instead of being added at the end of the year; and n stands for the number of years or time period before the future cash flow occurs. However there can be multiple cash flows that have to be discounted in a different way. The importance of discounting future cash flows by using these formulas also depends on other factors as well. Discounted cash flows give a real picture of the future possibilities (Mei, 1994, p.69). Since DCF is what an individual is willing to pay at present in order to have what he expects to have in the future, it’s a process of expressing future revenue flows in terms of today’s value. Probably the most important reason behind DCF is the fact that inflation erodes the value of money in times to come, i.e. future (Powers and Castelino, 1991, p.100). Therefore it’s essential to make up for the loss. That is why in each subsequent DCF multiplied by the number of years, a lower value comes up. Persistent inflationary pressures in the economy make it more than sensible to discount future cash flows of companies in order to obtain a realistic value. Thus what’s obtained in consequence is the net present value (NPV) of an investment or an asset. The company directors have realized the importance of investing the extra cash in a portfolio of financial instruments but have not paid much attention to the benefits of DCF method in order to acquire a reasonable picture of future cash inflows. Any DCF method, especially NPV, would help the company to achieve a fairer forecast for its future cash flows which in turn are influenced by the future cost of capital, i.e. interest rate (Aven, 2008, p.52). Q. 2. (b). b) Susie Lee owns the Lotus Blossom Bar and Restaurant. Lee’s decision to make the investment is based on the apparent returns by way of future cash flows and it does not take into account the risk factor involved. For instance she has totally disregarded DCF method because she probably considers those future returns to be final and conclusive with respect to their values. The following DCF calculations and the NPV figure of the total investment of Lee show that her decision is fairly justifiable because the NPV is equal to £ 123,928.60 which is a considerable value against probable future inflationary pressure, i.e. the opportunity cost of capital (Heymann and Bloom, 1990, p.36). Year Cash flow Discounted cash flow 0 = £-(10,000.00) 1 10,000.00 = £ 8,928.57 2 20,000 .00 = £ 17,857.14 3 40,000 .00 = £ 35,714.28 4 50,000.00 = £44,642.85 5 30,000 .00 = £ 26,785.71 ----------------- NPV = £123,928.60 The opportunity cost of capital, i.e. the interest rate is equal to 12% (Pratt and Grabowski, 2008, p.4). Thus by adopting it as the discount rate for all future cash flows Lee can effectively obtain the NPV for them. This gives her a few advantages. In the first place proper financial management requires a realistic opportunity cost to be set against capital. Though over a period of 5 years there can be considerable pressure on interest rates, a steady return of earnings would be ensured through proper cash flow management (James, 2006, p.90). Conclusion Inflationary pressures might change the final outcomes to a greater extent. Assuming a constant rise in the rate of inflation, Lee would benefit from cumulative growth in cash flows if the current forecasts wee to remain steady. However even if the current forecasts were a little out of line, there would still be a steady cash flow return for Lee because an opportunity cost of 12% per annum ensures a considerable setting off of risk associated with such unforeseeable outcomes (Leiderman, 1993, p.39). Thus Lee’s decision to invest in the Lotus Blossom Bar & Restaurant is a sound decision. Despite financial market volatility investments and cash flow forecasts perform predictably well in accordance with agents’ behaviour and sentiments. Thus there is a highly plausible scenario of positive financial outcomes for Lee. Finally her decision to invest in this business would have a positive impact on company finances depending on the cash flow variances. Continuous positive variances would enhance the company financial performance over the period under consideration, assuming other variables such as external debt remains constant over the period. Lee’s decision to invest in the business is necessarily influenced by the fact that with a captive customer-base the business is less likely to falter. REFERENCES 1. Alexander, C. 2008, Market Risk Analysis: Quantitative Methods in Finance, John Wiley & Sons Ltd, West Sussex 2. Alexander, K., Dhumale, R., and Eatwell, J. 2005, Global Governance of Financial Systems: The International Regulation of Systemic Risk (Financial and the Economy), Oxford University Press, New York. 3. 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(Eds.), 2008, Handbook of Financial Intermediation and Banking (Handbooks in Finance), Elsevier Science, Oxford. Read More