Cash Flows Under Different Risk Management Decisions - Essay Example

Cash Flows Under Different Risk Management Decisions What are the real-world components of Ct, I & k for evaluating risk management activities The risk management decisions are always based on identifying the key risk indicators along with the profitability or benefits, which are associated with the risk management decision. In order to understand the risk management decision we need to first understand the risk. Understanding risk: Risk is referred to as the probability of loss. Higher probability of loss leads to more risk. In other words risk is associated with the potential to lose something which has some value. In every aspect of life risk is involved because of the uncertainty is present in the future. Therefore, the risk can also be called as the uncertainty of the future events (Crouhy, 2000). It can be explained in a way that we are not aware of the unexpected circumstance, which may happen in the coming future. Despite of the projections and planning, one cannot fight with the events which are out of the control of human beings. This can be explained with the example of common human being, who plans and takes decisions in his life with some expectations, which he believes will have more chances to occur in the future but if life does not move according to the expected circumstances so the person may face loss in his decision. Therefore, the chance of occurring unexpected circumstances is referred to as the risk of loss. The reason may be that the decisions may not move according to the plan (Hopkins, 2012). Risk can also be explained with more specified example of financial planning of a person, who projects his cash flows that will occur in the future based on the potential of his career growth. If the result of the decision is in accordance to his plan then he will be able to enjoy profits otherwise loss (David, 2008). Risk Management Decision Making: The job of any risk manager is to control the risk and identify more profitable option at the given level of risk. The risk level is determined using different risk based components and the then financial engineering is used to evaluate the results of the risk based decisions (McLucas, 2003). There are number of different concepts, which are used for the evaluation of risk management decisions. The risk managers are exposed to evaluate different projects in terms of their feasibility to start the project or not. An overview of one of the method, which is also referred to as the indicator for evaluating the project is called as Net Present Value. NPV is used to evaluate the following risk management decisions 1. Risk Retention 2. Risk Transfer 3. Risk Control 4. Risk Avoidance A brief overview of each of the above risk factors is as follows 1. Risk retention: The Risk Retention is the ability to retain or bear the risk. The risk management decision making process include the risk retention of the investor, to identify the risk taking ability of the investor for the project (Rejda, 2005). The reason may that if the risk taking ability of the investor, which is subjective factor, is quantified and identified more accurately then the investment decision making process becomes more strong and accurate. The results may help more accurately to the risk manager with respect to identifying more suitable investment for the investor in terms of its risk taking ability or risk retention level 2. Risk transfer it is also referred to as the risk management strategy for transferring the risk taking ability to other party. It may be explained in terms of insurance. The insurable risk is transferred to another party, which is referred to as the insurer by means known as insurance policy. The insurance policy transfers the risk which has more chances to happen in the future to other party known as insurer against a periodic payment, which is called premium (Micheal, 2005). 3. Risk Control: Risk Control means the process of identification and assessment of the risks that are expected to occur in the future. The mechanism can be used to prioritize the risk factors in terms of risk based decision making process. The major purpose of risk control strategy is to control the probability of uncertain events by prioritizing the key risk areas of the particular project (Borghesi, 2012). 4. Risk Avoidance: The Risk avoidance is referred to as the inability to take risk and the investor avoids taking excessive risk (Toma, 2012) i.e. (NPV) a brief discussion on the concept, component and implication of the components of NPV are as follows. Net Present Value Net Present Value is referred to as the financial indicator to evaluate the project in terms of risk management decision making. In other words, Net Present Value is a financial term to identify and evaluate, which project to select in terms of required investment and expected cash flows. (Damodaran, 2010) The result of Net Present Value can help the decision maker on the basis of projected cash flows and required investment that whether to undertake the project or not. It can also be explained in a way that on the basis of Net Present Value i.e projected cash flows and the investment that will be required to make whether the project is profitable or not. Net Present Value in Financial Terms In finance term Net Present Value can be explained in terms of series of expected cash inflows and outflows for undertaking a particular project. The result of expected cash inflows and outflows is used whether the project will prove to be profitable or not. It can also be defined as the sum of the present values of the expected cash inflows and outflows (Graham, 2011). If all the expected cash flows are inflows and the only outflow is the initial investment or purchase price of the project, the term present value of cash flows and Net Present Value (NPV) less the initial investment PV of Cash Flows = NPV of Cash flows – Initial Investment On the other hand, if expected cash flows may include both cash inflows and outflows, then the result may be different. Net Present Value is considered as the basic tool or equipment for the analysis of discounted cash flows. The Discounted cash flow analysis is referred to as the current value of the cash flows that will be received in the future. In other words, Discounted Cash Flow (DCF) analysis identifies the time value of money i.e what is the value of money today that will be received in the future. The DCF analysis or NPV is used in long term projects, in which the cash flows which include both inflows and outflows at different time intervals. The method can be widely or more commonly used in areas of finance and economics. The Net Present Value indicator measures and evaluates the shortfall or excess of the cash flows that will be generated at the end of the project. NPV can also be explained as the difference between the Cash inflows and Outflows. In other words, it is the sum of the cash inflows and outflows, which are discounted using relevant rates of returns or discount rates. The concept and implications of discount rate is discussed in the next section of the paper. Formula for NPV NPV = ∑Ct/(1+k)^t –I Components of NPV As in the formula above, it can be seen that the net present value is calculated using different components. A brief explanation of all the above components are as follows Ct--- Net Cash Flows K----Discount Rate t---Time period I--- Initial Investment Lets discus each of the above mentioned components, their use and implications regarding risk management activities discussed above i.e retention, risk transfer, risk control and risk avoidance Net Cash Flows The Net Cash flows is referred to as the projected cash inflows minus cash outflows. It is considered as one of the most important components of Net Present Value. The net cash inflows and outflows are projected in the case of evaluating the future project, which is expected to be started based on the result of the Net present value or DCF analysis. The cash inflows and outflows is a critical task to predict for a particular project. The reason may be the uncertainty that exists in the projection of cash flows. The cash inflows and outflows are projected based on the anticipated events but there are factors that may arise due to unanticipated events, which may change the actual result of project. The quality of anticipating or projecting more accurate events that will happen in the future improves the quality of the result of Net Present Value analysis. In order to identify more accurate results to mitigate the risk, the risk manager need to develop in depth analysis of the project and its relevant upcoming events that may have impacts on the cash inflows or outflows of the project, so the risk manager may be able to develop more fruitful results (Damodaran, 2010). Discount Rate The discount rate is used to discount the projected cash inflows and outflows to the present value of the cash flows. The discount rate can be used in terms of weighted average cost of capital, which is after tax. The other discount rates may be the required return on equity. The major difference between the two is that the discount rate based on weighted average cost of capital is appropriate when the higher rate is used to adjust for higher risk. It is also referred to as the opportunity cost, whereas the required return on equity which is calculated using capital asset pricing model is adjusted downward, thus increases the returns (Damodaran, 2010). Alternatively, the discount rate can be decided based on the return on the alternative project. In other words, it may be used as the opportunity cost of losing other profitable projects for the existing project. In numerical terms it can be explained in a way that if the other project may be able to earn atleast 5% return then the relevant discount rate for the existing project may be 5%. The reason may be that the investor is going to lose 5% return by not investing in alternative project. Therefore, in this case the weighted average cost of capital or CAPM model may not be used but a subjective judgement is used to evaluate the discount rate. Contrariwise, in most cases, WACC or CAPM is used for identifying the relevant discount rates Initial Investment The Initial investment may refer to the purchase price of the project or the amount which is required to make start up the project. The Initial investment may also be referred to as the initial cost of the project that is required at least at the minimum level. Therefore, identification of the more suitable amount that needs to be invested in the beginning of the project to get suitable returns is an important factor of risk based investment decision making process (Damodaran, 2010). Real World Components for Evaluating Risk Retention at NPV In the real world the risk retention activity can be evaluated after considering the amount which is currently available to invest. The budgeting process can be more helpful to evaluate the cash inflows and outflows. Practically, the cash inflows and outflows are hard to predict because of the large number of unanticipated events. Once the cash inflows and outflows are predicted more precisely along with the opportunity cost of pursuing the project based on the funds available to invest the risk taking ability can be more accurately evaluated. Therefore, the real world component of ct is the periodic cash flows that can be generated from the project and the investments in terms of restructuring cost or project enhancement cost that may be required during the project (Damodaran, 2010). Secondly the real world component of “I” at NPV is for evaluating the risk management activities such as risk retention, risk transfer, risk control and risk avoidance is the initial purchase price of the project, which may also be referred to as the amount required to get the suitable return. In the real world, the suitable investment can be explained as the identification of optimum level of investment required for the particular project. The last component i.e “K” the discount rate, as already discussed above can be decided based on the return on the alternative project. In other words, it may be used as the opportunity cost of losing other profitable projects for the existing project. In numerical terms it can be explained in a way that if the other project may be able to earn atleast 5% return then the relevant disount rate for the existing project may be 5%. b) Practical Suggestions for Estimating Realistic Values For the Variables Identified: After the detailed discussion of the variables or components of NPV, it is suggested that the results of NPV can be more realistic if the components can be identified more accurately. The best way to identify the components or variables of NPV more accurately is that the cash flow projection must be based on maximum possible anticipated events in the future. In addition to this, the discount rate must coincide with the relevancy of the project. In order to evaluate the equity based project using WACC is not suitable but CAPM may be more feasible. Moreover, the relevant time period of the project must be predicted properly. Unrealistic or infinite time frame for the project may not lead to the judgemental results. Lastly the investment amount must be more reasonable and must include only the investable amount not the whole amount available with the investor. Decision Making Process of NPV If the Net Present Value analysis results in positive value this implies that the project is suitable and should be started. Contrariwise if the results are negative then the project may require more cash outflows than the inflows, which reflects the losses. (Graham, 2011). Bibliography Borghesi, A., 2012. Risk Management : How to Assess, Transfer & Communicate Critical Risk. s.l.:Springer. Crouhy, M., 2000. Risk Management. s.l.:McGraw Hill Professional. Damodaran, A., 2010. Applied Corporate Finance. s.l.:Wiley. David, M., 2008. Understanding Risk: The Theory & Practice of Financial Risk Management. s.l.:Taylor & Francis Group. Graham, J., 2011. Introduction to Corporate Finance. s.l.:Cegag Learning. Hopkins, P., 2012. Fundamentals of Risk Management: Understanding, Evaluating & Implementing Effective Risk Management. 2nd ed. Philadelphia: Kogan Page Limited. McLucas, A. C., 2003. Decision Making: Risk Management, Systems Thinking & Situation Awareness. s.l.:Argos Press. Micheal, F., 2005. Risk Management: Challenge & opportunity. s.l.:Springer Berlin. Rejda, 2005. Principal of Risk Management & Insurance. Delhi: Pearson Education. Toma, M., 2012. Risk of Trading. s.l.:Wiley. Read More