The Approaches a Non-Financial Company Should Take in Managing Risk Inherent in a New Project - Coursework Example

THE APPROACHES A NON FINANCIAL COMPANY SHOULD TAKE IN DEFINING, MEASURING AND MANAGING THE RISK INHERENT IN A POTENTIAL NEW PROJECT –A CRITICAL EXAMINATION The Approaches a Non-Financial Company Should Take in Defining, Measuring and Effectively Managing the Risks Inherent in a Potential New project- A Critical Examination 1. Introduction For every company, it is needed to assess whether a proposed investment project is feasible or not. An objective and systematic framework for this purpose is known as project appraisal (Savvides, 1994;Dugdale and Abdel Kader,1999). Project appraisal is very essential for the change and development of a company (Brealey and Myers,2000; Schuster, 2007). One of the most important and difficult component of project appraisal process is considered to be risk analysis, which increases the validity of investment decisions (Savvides, 1994; Tham and Lora, 2001). This essay critically examines the approaches to be taken by a non-financial company for the risk analysis and management of a proposed project .In the second section, the various investment appraisal techniques are critically discussed. In the third section, the risk analysis methods based on the outcomes of the investment appraisal techniques are discussed. The fourth section concludes the essay. 2. Investment Appraisal Techniques- A Critical Discussion The three main investment appraisal techniques are payback method, accounting rate of return method and the net present value method(Rohrch,2007).According to the payback method, there will be a target payback for a company, and so it would reject a capital project unless its payback period were less than that target payback period. Payback period is defined as the time required for the capital for the cash inflows from a capital investment project to equal the cash outflows. P = I/ CI----------(1), where P is the payback period, I is the investment required and CI is the net annual cash inflow. Figure 1: Cash Flow Diagram - Loan Transaction Source: engineeringtoolbox.com(2009) Note: See appendix 1 Figure 2: Cash Flow Diagram - Investment Transaction Source: engineeringtoolbox.com(2009) Note: See appendix 1 According to the accounting rate of return method, a project appraisal involves estimating the accounting rate of return that a project should yield. If it exceeds a target rate of return then the project is acceptable. The Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage of the capital outlay. Its main advantages are that it can be easily calculated from financial statements and considers the entire project life. However, the main limitations associated with this method are that it does not consider the project timing, relative measure without considering the investment size, based on accounting projects instead of cash flows, ignorance of the length of project and the time value of money(Baddeley,2006). ARR = (AP/ O)*100------- (2), where AP is the average accounting profit and O is the capital outlay. According to the net present value method, the decision rule is to accept a project with a positive Net Present Value (NPV). The net present value of a project is the difference between its projected discounted cash inflows and discounted cash outflows. NPV= PCI –PCO------(3), where PCI is the projected discounted cash inflows and PCO is the projected discounted cash outflows. Its main advantages are that it considers time value of money, all relevant cash flows, incorporates risk, direct measure of wealth maximization and clear decisions. Though NPV method is considered to be theoretically superior over other methods generally, it has been criticized with regards to the difficulties in practical sage like complexity, errors and the assumptions like shareholder value maximization(Graham and Harvey,2001). Moreover, it is criticized on the fact that it is concerned only with liquidity and not with profitability(Arnold and Hatzopoulos, 2000).Pogue (2004) criticized NPV method on the theoretical assumption of discrete estimated cash flows instead of assuming continuous cash flows. In spite of the suitability of this assumption for financial investments, it is shown that for corporate investments in new technologies or new products, it might give misleading results. All the above methods however assume perfect capital markets and hence certainty in decisions which may not be the case in reality. Hence, Shuster (2007) has put forward the Visualization of Financial Implication methods (VoFI) for cases with imperfect capital markets. Here uncertainty and the inseparability of consumption and investment decisions are assumed. Many studies have argued that the investment appraisal using discounting techniques method is of little worth when the uncertainty about the project and its operating environment is very large. In such case, the project appraisals can be very expensive, the benefits may not match with the high costs, and hence the techniques can be of little worth (Little and Mirrlees,1991).However Little and Mirrlees(1991) shows that though the value of appraisal is reduced under high uncertainty, in principle it can be considerable. Further, it is argued that these techniques are extremely sensitive to the choice of discount rate .Hence for very risky projects, the high risk needs to be reflected in extremely high discount rates. However, no generally accepted methods are there to quantify the risks or to incorporate them into the discount rates. Hence, the traditional long-term investment appraisal techniques are criticized for their treatment of risky projects like Information Communication and Technology (ICT) investments and Information Services (IS) projects (Milis et al, 2008). Miles et al (2008) classify the risks associated with IS services as assessment risk, technical risk, project risk and functional risk. It is shown that the traditional investment appraisal techniques fail to incorporate these risks in their discount rates. Further, it is argued that there can be a tendency for the decision making to tilt towards the accepting unreasonable short term solutions due to a combination of high risk and long term pay offs when the traditional techniques are used for high risky projects.. Though many adjusted techniques improve the worth of the appraisal, there are problems associated with the interpretation of these techniques (Millis etal, 2008). In spite of these arguments there is an increasing pressure for using the traditional investment appraisal techniques .This argument is based on the assumption that the main aim of an organization is profit maximization and maximization of the shareholder’s wealth. Further, this is also based on the argument that common techniques are needed for all decisions regarding investments due to the ease in applying them. This argument however neglects the case of high risky projects like ICT investments and IS projects. In the next section, the risk analysis in the investment appraisal process is critically examined in detail. 3. Risk Analysis 3.1. Financial Risks Three main tools are identified in the analysis of financial risks for a proposed project (Tham and Sabin, 2001). They are (1) producing and analyzing probability distributions of the outcome of a project like Net Present Value (NPV) or Internal Rate of Return (IRR) (2) the use of risk adjusted discount rates and (3) certainty equivalent approach. Based on the desired outcome of a project like NPV or IRR, the probabibility distributions are estimated and analyzed as a first step in the risk analysis (Savvides, 1994). For this purpose, first, a forecasting model, which has predictive ability of the future, is estimated and then the risk variables in the model are identified by sensitivity and scenario analysis based on Monte Carlo simulation. The probability distributions of these risk variables are specified and discounted by risk free discount rate and based on simulations of these future cash flows, the probabibility distributions of the desired outcome are produced. Then they are examined by analysts for decision-making. Based on these, there is possibility of accepting a project with lower NPV or rejecting a project with marginal positive vale due to better or low risk return profile (Savvides, 1994). There are many limitations however, with this approach of producing and analyzing probability distributions. One is the difficulty in interpreting the probabibility distributions due to the presentation of multiple prices instead of a single risk adjusted price and the difficulty in choosing an appropriate discount rate for producing the probability distribution, which is a highly debatable issue. Moreover, the change in the nature of the selected risk variables over the life of the project is not specified which makes the interpretation difficult (Tham and Sabin, 2001). The second main tool in financial risk analysis is the use of a risk-adjusted discount rate. This includes taking care of the risk involved in the project by adjusting the return on equity by a certain percentage. The decisions are made by the equity investors by comparing the expected risk profiles of the given project with those of another projects (Brealey and Myers, 2000).However, it is shown that a single risk adjusted discount rate is appropriate only for a project with constant market risk in its entire life. For projects with non constant market risks, it is recommended to divide the project into segments for which the same discount rate can be used(Tham and Sabin,2001).The main limitation associated with the risk adjusted discount rate is the subjectivity associated with defining the risk involved in a project and the quality of the subjectivity (Holton,2004). The final tool involved in financial risk analysis is the use of certainty equivalent approach in which separate adjustments for risk and time are made. In this method, the smallest pay off for exchanging the risky cash flow by the investor is examined (Tham ad Sabin, 2001). The main drawback associated with this approach is the difficulty in finding suitable adjustment factors for each year in a project ,which is similar to the determination of risk adjusted discount rates . This again is subjective which has its own limitations (Holton, 2004).The certainty equivalent approach can be shown in the following figure. Figure 3 Source: Baumol(2000) In figure 3, two projects A and B are considered. Here, the decision maker must specify how much money he must be assured of receiving, to make him indifferent between this certain sum and the expected value of a risky sum. The certainty equivalent factor α= (Certainty- Return)/ (Risky-Return). For A, α = 0.33 and for B, α = 0.5. In this case, A is more risky . 3.2. Non Financial Risks The main non-financial risks to be considered in investment appraisal can be classified as economic, social and political risks (Nagi, 1984). The change in the economic structure or growth rate like fiscal changes, monetary changes and international changes are included in the economic risk factors. These are argued to cause significant change in the return of an investment. . The instability and the political actions of government like attitude towards investment in a project are included in the political factors. These are supposed to affect the investment. Social and natural factors include risk arising from technological changes, environment changes etc (Meldrum, 2000). 4. Conclusion Based on the essay here, it can be concluded that deciding on a proposed investment project is a very crucial matter concerning each company. In this essay, various investment appraisal techniques are discussed. The discussion shows that the traditional investment techniques have their advantages and disadvantages. These techniques are universally accepted and is well known among the practitioners. Hence, there is increasing pressure for using these in spite of their disadvantages. The evidence for less risky projects supports using the investment appraisal techniques to a certain extent. At the same time, the usefulness of these techniques has been doubtful in the case of high risky projects. In this case, it is very difficult to incorporate risk into the discount rate selected due to the unavailability of generally accepted techniques in this regard. The extreme sensitivity of the appraisal techniques to the selection of discount rate makes this problem particularly relevant. In addition to this, there is the problem of over assessment or under assessment of the discount rate, selected. This is especially relevant in the case of high risky projects like ICT and IS services projects. Though there have been some techniques adjusting for the risk, the interpretation of these are found to be very difficult. However, in the absence of appropriate and generally accepted alternatives, these techniques are the only available option for decision-making. Finding new methods and discounting techniques for riskier projects like ICT and IS service projects are quite fruitful areas for further research. Risk analysis acts as a supplement enhancing the decision-making on investment. A non-financial company needs to generate and assess probability distributions, estimate the risk adjusted discount rate and certainty equivalent approach for analyzing financial risks. All these steps need to be done with great caution taking care of the limitations involved in each step. In addition to these, the non financial risks like economic, social and political also needs to be considered for a project. References Arnold, G and Hatzopoulos, P. (2000), "The theory-practice gap in capital budgeting: evidence from the UK", Journal of Business Finance and Accounting, Vol. 27 pp.603-26. Baddeley M (2006): “Behind the black box: a survey of real-world investment appraisal approaches”, Empirica, Volume 33, Number 5. Baumol W J (2000): “Economic Theory and Operations Analysis”, New Jersey: Prentice Hall. Brealey R A and Myers SC (2000): “Principles of Corporate Finance”, Boston: Irwin McGraw Hill. Dugdale, D and Abdel-Kader, M G(1999): “Funding Issues in a Major Strategic Project: A Case of Investment Appraisal” Accounting Education: An International Journal, Vol. 8, No. 1, pp. 31-45. Engineering toolbox.com(2009): “Cash Flow Diagrams”, http://www.engineeringtoolbox.com/cash-flow-diagrams-d_1231.html, Accessed January 2010. Graham, J.R., Harvey, C.R. (2001), "Theory and practice of corporate finance: evidence from the field", Journal of Financial Economics, Vol. 60 pp.187-243. Holton G A (2004): “Defining Risk”, Financial Analysts Journal, Volume 60, Number 6, CFA Institute. Little I.M.D and J. A. Mirrlees(1991) : “Project Appraisal and Planning Twenty Years On” ,Proceedings of the World Bank Annual Conference on Development Economics 1990,Washington:World Bank. Meldrum D H (2000): “Country Risk and Foreign Direct Investment”, Business Economics, 35 (1), pp.33-40. Millis K, M Snoeck and R Haesen (2008): “Evaluation of the applicability of investment appraisal techniques for assessing the business value of IS services”, National Bank of Belgium, project NB/08/06. Nagy PJ (1984). “Country Risk: How to Assess, Quantify, and Monitor it?”, London: Euro money publications Pogue M (2004): “Investment Appraisal: A New Approach”, Managerial Auditing Journal, Volume 19, No4, pp565-569. Rohrich M (2007): “Fundamentals of investment appraisal: an illustration based on a case study”, München [u.a.] Oldenbourg. Savvides, S C (1994) “Risk Analysis in Investment Appraisal”, Project Appraisal Journal, Vol. 9, No. 1, March. Schuster P (2007): “Investment Appraisal at Imperfect Capital Markets”, International Business and Economics Research Journal, Volume 6, No 9, p21-28. Tham, J and Sabin L (2001) “Conceptual Issues in Financial Risk Analysis: A Review for Practitioners”, February. A: http://ssrn.com/abstract=259508, Accessed January 27 2010. Appendix 1 A Cash flow diagram shows all cash inflows and cash outflows plotted along a horizontal time line. In figure 1, upward arrows indicate positive cash flow or receiving the loan. The downward arrow indicates negative cash flows or paying off the loan. In the second figure (figure 2), upward arrow shows positive cash flows or payback and downward arrow shows negative cash flows or investing. Multiplying each cash flow with the discount rate gives the Present Value of the cash flows. Read More