Evaluating the Value of the Project - Essay Example

What are the real-world components of Ct (cash flows at time t), I (initial investment) and k (discount rate) for evaluating the following types of risk management activities at NPV?  A corporation is an entity whose ownership belongs to shareholders while is run and managed by managers. The main aim of managers is to maximize the share price by adding value to the firm. Their decisions should focus at improving the value to the firm instead to achieving personal goals. The value is added to the corporation by accepting certain projects. But almost all of the projects carry certain amount of different types of risks such as credit risk which is other party goes default or not in a position to pay their obligations, market risk that are the changes in market prices will impact the portfolio, liquidity risk that is the risk of higher cash outflows than the cash inflows leading to shortages of funds or operational risk that is technical failure or any fraudulent activity in the corporation. Therefore every project has to be evaluated whether the value the project is delivering is enough to take the risk accompanied by the project. For this purpose Net Present Value is used as a bench mark in decision making. Net Present Value: In order to add value to the firm, the management has to take certain decisions regarding which projects should be undertaken and which should be disregarded? For this purpose discounted cash flow technique is used known as Net Present Value (Wang, 2003). NPV is the sum of all discounted cash flows both inflows as well as outflows. Higher the Net Present Value higher the value being added by the project. If Net Present Value is Positive Project is adding value Accept the Project If Net Present Value is Negative Project is taking away the value Reject the Project If Net Present Value is Zero Project is neither taking away nor adding any value Either Accept or Reject, at management’s will Risk management activities are divided on the basis of the probability of failure and the consequence it would hold in case of failure. There are four risk management activities (Spaulding, 2005): The risk Matrix below (Alexander and Marshall, 2006) Risk Retention: Risk retention is accepting the risk, evaluating how much loss it can incur then allocating funds for the purpose of compensating for the risk. Risk retention is the best strategy when the probabilities of failure as well as the consequences of failure are the lowest. Value at risk is determined and a pool is created to make for that loss. Retention is a sort of self insurance. Retention groups are made to avoid the high cost of insurance premium that is incurred if insurance is made for the losses that might incur in long run through regular insurance companies. Self insurance is also used if regular insurance facility is not available in the area of operations. All losses incurred are net cash outflows. Other cash outflows include corporate income tax payments as well as interest payments while other gains are cash inflows. Risk adjusted LIBOR taken as discount rates are considered while Initial Investment includes risk pool set apart to account for losses to be incurred. Other initial investments include all other investments that were made for purchasing the assets as well as other investments in the project. All the cash flows are the gains or revenues as the inflows while all the losses are counted as outflows. Risk Transfer: Risk transfer is transferring the risk to a third party. Insurance and hedging are based on risk transfer approaches. Hedging occurs if bond and security is purchased and linked to another underlying asset or when risks are reduced by involving future transactions. In this case the corporations risk is reduced which is being transferred to any third party through a contract. Insurance is also the transferring of the risk to a third party which is the insurance company. Insurance is purchased for any loss that might incur in the future and a regular outflow known as insurance premium is paid to the company which in return makes up for the loss when the loss is actually incurred and a claim is made to the insurance company which in return generates an inflow to the company if claim is approved. Risk transfer is the best approach when although the consequences are worst but the probability of occurrence of failure is the lowest. Warranty is also a type of Risk being transferred to a third party. Cash flows include dividends in case of securities, coupon payments in case of bonds in futures and premiums in case of insurance claims where as Claim amount is the cash inflow. Other cash flows include margin paid to the exchange or insurance premium in case of getting insured which is the regular outflow. Other initial investment includes amount paid to purchase the future or asset such as derivatives, bonds or securities. Discount Rate is London Inter Bank Offered Rate + some basis points. Initial investment also includes all other investments initially made for the purpose of purchase of any plant or setup of the project. Hedging contract or options also include a premium that has to be paid as a cash outflow. Other profits or revenues act as inflows Risk Control: Risk control is identifying the risk and then reducing it through various means. Risk can be controlled through investments in derivatives such as swaps, forwards and options etc (Tommy, 2010). Options give the buyer the right to buy a pre decided product at a price already set in the contract and seller has an obligation to sell at the strike price mentioned. Swap is also a type of derivative where cash flows are exchanged. Forward is an agreement to buy or sell an asset at a pre decided price and at a specific time in the future as decided in the contract. It is to control the corporation against any potential risk. Risk control approach is the best when the consequences of failure are limited but the probability of occurrence of failure is very high. Arbitrage is also a risk control activity. Although it is difficult to find the opportunity of arbitrage but if found then it facilitates money making out of nothing. Cash Flows are dividends in case of securities, coupon payments in case of bonds. Other cash flows include gains and losses incurred in derivatives. Interest as well as the corporate tax is the cash outflows. Discount Rate is LIBOR plus basis points. Initial Investment is the price paid to purchase the security or a bond or a forward contract or an option. In case of future Settlement price is also an outflow. In case of an option, option premium is an out flow. All other profits or revenues are cash inflows. Risk Avoidance:  This is the most basic type of corporate risk management activity that is being risk averse. In each and every investment if risk is seen that action, project or investment is avoided. Although every risk can be avoided by this approach but every profitable project has some risk, so in order to avoid risk, a huge amounts of profits are also missed which is not the right approach in business. Therefore this is best in the case when the probability of failure is the highest and consequences of failure are the worst. Such projects should be avoided at all costs. In risk avoidance since all the projects that possess risk are avoided so in most of the cases projects are not taken therefore Net Cash Flows, Discount Rates and Initial Investments are all nil. If a risk free project had been taken than net price value should be positive with high value. Cash inflows are revenues coming in while cash out flows are the expenses incurring or losses occurring or all the money that is going out either in the form of taxes or interest payments. Initial investment is initial cost of the project that is being incurred in the purchase of the product. Thus major components on Net Present Value equation includes Cash flows where all cash coming in as revenue are inflows and are positive while all cash flows going out as expenses are cash out flows which are negative. Net cash flows is the sum of all the cash out flows as well as cash inflows. If Net Present value is negative, it means more cash flow is going out then discounted cash flow that is expected to come in the future. b) Provide practical suggestions for estimating realistic values for the variables identified The net cash flow is the sum of all the cash inflows as well as the cash outflows. Cash inflows are positive that is all the money that is coming in while all the cash outflows are negative that is all the money going out of the business. Initial investment is the cost that is used initially for the setup or the purchase of asset or plant etc. NPV= (Brigham and Ehrhardt). Risk Retention: In risk retention a pool is created to make up for the losses that could occur. That loss pool is the cash outflow that is calculated through Value at Risk calculated by formula that is Value at Risk= (Expected Profit / Loss)-Worst case loss at given confidence level. Discount rate is interest rate or Eurodollar rate or London Inter Bank Offered Rate. Discount rate= interest rate risk free +Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Risk Premium (Brigham and Ehrhardt). Risk Transfer: Discount rate is interest rate or Eurodollar rate or London Inter Bank Offered Rate plus some basis points as decided. Discount rate= interest rate risk free +Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Risk Premium (Brigham and Ehrhardt). Insurance Premium = (Probable loss x loss Probability) + General and Administration Expenses + profits Dividends are announced by the company and are increased by the sustainable growth rate. Growth rate for dividends and earnings is calculated by: Sustainable Growth Rate = (1-Dividend Payout Rate)*Return on Equity Risk Control: In arbitrage spot rates or discount rates are determined through the procedure of bootstrapping that is from the prices of coupon bonds. Discount rate is interest rate or Eurodollar rate or London Inter Bank Offered Rate plus some basis points as decided. Price of forward contract of bonds is determined by Forward Price=Price of underlying asset (1+discount rate) maturity Price of Forward contracts of stock is determined by Forward Price= (Price of underlying asset-Dividends Present Value)*(1+discount rate)maturity (Brigham and Ehrhardt). Other cash flows are determined through exchange rates or other rates initially decided at the time of contract. Dividends are announced by the companies and are increased by the sustainable growth rate. Growth rate for dividends and earnings is calculated by: Sustainable Growth Rate = (1-Dividend Payout Rate)*Return on Equity (Brigham and Ehrhardt). Net Cash flow also includes net pay off = Payoff at maturity – cost of establishing position (Brigham and Ehrhardt). Risk Avoidance:  Discount rate is interest rate or Eurodollar rate or London Inter Bank Offered Rate plus some basis points as decided Discount rate= interest rate risk free +Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Risk Premium Cash flows as well as rates are adjusted for inflation Real Cash flows = nominal cash flows/ (1 + inflation rate) t 1+real rate = (1+nominal rate) / (1 + inflation rate) (Brigham and Ehrhardt). References: Alexander, Corinne and Marshall, Maria I. 2006. The Risk Matrix: Illustrating the Importance of Risk Management Strategies, Tools of the trade, 44.2, [Online], Available at < http://www.joe.org/joe/2006april/tt1.php > Brigham, Eugene F. and Ehrhardt, Michael C. Financial Management. 10 ed. Pp 339-499. Spaulding, William C, 2005. Handling Risk. [Online], Available at < http://thismatter.com/money/insurance/handling-risk.htm> Tommy, 2010. Futures, Forwards, Options, Swaps. [Online] Available at Wang, Jiang, 2003. Present value. 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