Corporate Risk Management, Physical Risk Consideration in Capital Budgeting - Essay Example

? Corporate Risk Management Contents Contents 2 Introduction 3 Firm’s exposure to physical risk 3 Physical Risk consideration in Capital budgeting 5 Physical Risk measurement in Capital Budgeting 6 Conclusion 7 References 8 Introduction The firms should considers the physical risk factor in the business while applying the capital budgeting techniques for evaluating the net present value or the internal rate of return of the business. The consideration of the physical risk of the business to the fullest extent would help the companies to calculate the rational value of business and decide on the feasibility of the business investment. The physical risk could be posed to the business in the form of fire explosions, accidents at workplace, hazardous material spills, etc. The expenditures of the business in order to compensate the physical damages of workplace and manpower could serve as important inputs in the process of capital budgeting that has the objective to determine the actual net present value and internal rate of return of the business (Shapiro, 2008, p. 42). Firm’s exposure to physical risk The physical risk is the foremost risk that affects the organization and its people. The establishments, factories, plants and buildings in which the business is carried out as well as the employees of the business house are subject to physical risk. The physical risk to the business occurs as result of the uncertainty of the occurrence of unforeseen situations and accidents that badly affects the infrastructure of the business and its entire business set up. The physical risk may occur due to the unfortunate incidents of fire breakout in the company buildings. There may be accidents as a result of the explosions happening inside the workplace (Megginson and Smart, 2008, p. 63). The companies spend substantial amounts in setting up the business infrastructure. A huge amount of expenditure is incurred by the business in constructing the office set up, the interior decoration and the wooden construction for making the buildings and its rooms suitable for official use. The other expenditures include glass fittings, work place arrangement of improved designs. The corporate look in the offices is due to the standardization of the infrastructure for business that is required to be established in the workplace. The occurrence of fire accidents and small explosions inside the office buildings are huge risks as it destroys the infrastructure for carrying out business operations and also injures or adversely affects the manpower resources of the business. The physical risk for the business may also be due to the spillage of hazardous materials in the workplace. The hazardous materials like the acids, gases, toxic wastes, and toxic fumes could adversely affect the employees of the company which would in turn affect the business operations. Physical Risk consideration in Capital budgeting The capital budgeting techniques are aimed at assessing the feasibility of the business investment in a particular project. The capital budgeting techniques assess the viability of business investments with the help of various approaches that determines the extent to which the business is profitable. The assessment of the business takes into account the risk of the business. The physical risks associated to the business takes into account the several factors of uncertainty that would reduce the net valuation of the business or the expected return from the business investments (Chandra, 2008, p. 96). The consideration of the physical risk is thereby necessary to determine the feasibility of the investments through Capital budgeting techniques. The various capital budgeting techniques used to judge the viability of the investment are the Net Present Value method, the Internal Rate of Return, etc. The Net Present value of the business is the actual present value of the business adjusted with the initial investments required for starting the project (Lumby, 1988, p. 84). The Net Present Value, Internal rate of Return technique takes into account the forecasted cash flows of the business for a certain period of time in future. The forecasted cash flows of the business is discounted by the cost of capital of the business in order to find the present values of the cash flows which is then adjusted to the initial investment of the project. The consideration of the physical risk is essential in order to calculate the net present value, internal rate of return of the business in a rational manner. The elimination of the physical risks is likely to produce an inflated net present value of the business. A consideration of the physical risk to the fullest extent in the capital budgeting procedures would provide useful information on the adjustments in cash flows that need to be taken into account (Jones, 2007, p.26). The losses incurred due to the fire explosion and accidents resulting in physical damages of the buildings and the business infrastructure would require the company to incur additional expenditures that were not planned. This would reduce the net cash flows for the business and as a result the net present value of the business is likely to decrease (Peterson, Fabozzi and CFA, 2004, p. 62). Thus the actual estimation of the viability of the business through the capital budgeting process could be done by considering the physical risks. The consideration of the physical risk would also help to find a more rational value of the internal rate of return without which the companies would not be able to consider the impact of physical risk on the business. Physical Risk measurement in Capital Budgeting The physical risk measurement procedure is an important part of the capital budgeting process. However, it is difficult to quantify the risks in order to adjust the net cash flows with the uncertain cash outflows that could take place in case of fire explosion, property damages, spill of hazardous materials, etc. In order to account for the uncertain events, the business could take into account the historical records of similar accidents that have taken place in the past. A review of the unforeseen events that have taken place in the workplace that had physical impacts on the business and its people could be assessed in order to assess the likely physical risks that could take place. The amount of properties and the valuation of the infrastructure damaged due to the physical risk factors need to be calculated by the business (Khatta, 2008, p. 46). The business should be aware of the expenditures that have been incurred by them in order to compensate for the damages that have been caused due to the accidents and the unfortunate events. It is not only the amount of compensation for the properties; the business had to bear the expenses on medical treatment of the employees who have been affected by the physical damages. All these are outflow of cash that has occurred in the past due to the physical damages. The loss of manpower has also resulted into loss of revenue for business (Handlechner, 2008, p.47). Taking all these factors into consideration, the provision for anticipated cash outflow in case of physical risk should be created and the net c ash flows should be adjusted to find a rational net present value and internal rate of return of the business. Conclusion The assessment of the physical risk in the process of capital budgeting is important for the companies in order to determine the net present value and the internal rate of return of the business. The anticipated damages and the expenditures that could be incurred by the company in case of accidents, fire explosions, and hazardous material spillage are estimated with the review of the similar incident that happened in the past. The consideration of the cash outflows on account of such physical damages help in finding the accurate value of net cash flows of the business. The accurate value of the net cash flows in the business help to determine the rational value of the business and gives a correct picture of the internal rate of return that could be achieved. References Khatta, R. S. 2008. Risk Management. New Delhi: Global India Publications. Handlechner, M. 2008. Risk Management. Berlin: GRIN Verlag. Megginson, W. L. and Smart, S. B. 2008. Introduction to Corporate Finance. New York: Cengage Learning. Lumby, S. 1988. Investment Appraisal and Financing Decisions. London: Taylor & Francis. Peterson, P. P., Fabozzi, F. J. and CFA. 2004. Capital Budgeting: Theory and Practice. New Jersey: John Wiley & Sons. Chandra, P. 2008. Investment Analysis 3/E. New Delhi: Tata McGraw-Hill Education. Jones, C. P. 2007. Investments: Analysis And Management, 9Th Ed. New Jersey: John Wiley & Sons. Shapiro. 2008. Capital Budgeting And Investment Analysis. New Delhi: Pearson Education India. Read More