The Implications of the NPV Equation for Corporate Risk Management Decisions - Coursework Example

The Implications of the NPV Equation for Corporate Risk Management Decisions 0 Introduction Corporate risk management decisions relating to projects cannot be effectively evaluated using the NPV equation. The fact that any changes in the components Ct and k can change the decision is critical to risk assessment. It is for that reason that this paper assesses the process by which the NPV technique accepts and rejects projects. This paper looks at the NPV equation by breaking down the NPV into its constituent parts - cash flows (Ct), the cost of capital (k) and the initial capital outlay (I). It then uses the real world components of Ct, k and I and evaluates them using various risk management activities at NPV. 2.0 The Net Present Value (NPV) Equation The net present value (NPV) method is a very popular method of investment appraisal. It is used to calculate the difference between the present value of cash coming into a business (cash inflow) and cash going out (cash outflow). It provides information on whether a project should be undertaken. If the NPV is positive then the project is expected to provide positive cash inflows and if NPV is negative cash outflows are expected (Titman et al 2013). The formula for calculating NPV is given as: n Ct NPV =  - I t=1 (1+k)t In this formula Ct represents cash flows which can either be positive (inflow) or negative (outflow). The discount rate, k is normally calculated using the weighted average cost and capital (WACC) formula and therefore takes into consideration the proportion of equity and loan in the organization. The initial capital investment (I) is the cost incurred at the start of the project. This amount may be financed through borrowing, equity in the form of retained earnings and or the issue of shares, or combining equity with debt (loan). 2.0 Real World Components of Ct, k and I The real world components of Ct are the revenues generated from the project less expenses including depreciation of assets but excluding interest expense. The interest expense is excluded because the cash flows are discounted using k in order to reflect the time value of money. Ct represents cash flows that are generated by the project. The aim of NPV is to use these cash flows and discount them at the rate of k to determine if a project is worth undertaking. In the case of k, the real world components are determined bythe organizations approach to financing its projects and the business generally. The components are usually debt and equity and so the cost of each component is required to calculate the cost of capital. The cost of debt is the interest rate paid on borrowing by the company. This may be an average of several borrowing rates if the business has several loans or simply one rate in the case where the company has only one loan. The formula of calculating the cost of debt is: Cost of debt = rd(1-T) The cost of debt (rd), is the interest rate payable to the lender. This interest rate is adjusted by the tax rate (T) since tax expense is an allowable deduction for taxation purposes. It is described as the after-tax component of debt (Brigham et al 2005). The cost of equity is based on the return on shareholders investment in the business. This return depends on how the business is financed. The formula for calculating cost of equity using the capital asset pricing model (CAPM) approach is: re = rRF + (RPM)b The cost of equity (re) is the cost to the company of using equity, whether in the form of retained earnings or issuing new shares to fund projects. The risk free rate (rRF), is the risk free rate of interest and is usually the treasury bill rate (Brigham et al 2005). The risk premium (RPM), represents the difference between the expected market return and the risk free rate. The index of the riskiness of the company is represented by its beta, b. 2.1 Risk Management Strategies It is assumed that managers will take on those projects that have positive cash flows and reject those that do not (Heaton 2002). However, risks are still involved in every project and so cash flows may not occur as planned. Therefore, the manager may consider using risk retention, risk transfer, risk control and risk avoidance strategies to counter the effects of uncertainties. Additionally, changes in the discount rate due to inflation can affect k. A risk matrix illustrating the probabilities and consequences of these strategies is provided the Appendix. 2.1.1 Risk retention Risk retention is dependent on the level of risk inherent in a project. If a higher proportion of equity than debt is used then the company retains the risk for the project. Risk retention is evaluated by an assessment of the probability of the project being high, medium or low risk. If the risk is low then the project can be funded from internal sources thus retaining the risk (Kallman n.d.). The variability of Ct is normally taken into consideration as this can have a negative impact on NPV. In fact, it can change a project with a positive NPV into one with a negative NPV and that is why an assessment of the risks attached to the components, the revenues and expenses associated with the project. If the variability of Ct is minimal and the level of uncertainty is low then risk retention is favoured. However, if there is high variability in cash flows and the level of uncertainty is high then risk retention should not be considered. In such a scenario risk transfer or risk avoidance is recommended. However, risks associated with variations in cash flows can be controlled through proper planning. The cost of capital (k) for a project is normally dependent on how the initial capital outlay (I) is funded. If the project is funded with loans and lenders feel that the risk is high, this is normally reflected in the interest rate charged. These high rates are factored into calculating NPV and may therefore change the results from positive to negative. In such a scenario it may be better to use equity in the form of retained earnings to finance projects of that nature. However, there are also liquidity risks as funds tied up in a project which is not generating enough revenue based on the projections may increase the risk of insolvency. 2.1.2 Risk transfer Risk transfer is the process of transferring risk to a third party. If the business impact of taking on a project is catastrophic and the probability of the project failing is high then the risk should be transferred. There are many reasons for which a project may be catastrophic. Cases that serve as good examples are devastation of crops due to heavy rainfall, drought or disease in relation to agricultural projects. Catastrophes like these affect Ct. Insuring such a project is one of the principal method of transferring risk to a third party. Another popular risk transfer strategy is hedging. This strategy is particularly effective when foreign currency is involved. In order to prevent losses due to changes in exchange rate hedging strategies such as forward contacts or futures contracts are useful as they reduce the level of risk and uncertainty affecting Ct. This has implications for the decision to accept the project. Forward contracts allow for price to be agreed at the date of the contract for delivery at a specific date in the future. A forward rate is set and cannot be changed. Therefore, cash flows (Ct) for investments for which receipts are in foreign currency can be protected against price changes using this method. Futures contracts operate in a manner that is similar to forward contracts. Since the business will have foreign currency to sell, a futures contract can be sold by a process known as short hedge. This will reduce the risk of losses from foreign currency fluctuations. 2.1.3 Risk control The risk of the project can be controlled by performing an analysis. Based on the results the manager is able to determine whether they are financial, legal, environmental, operational or otherwise. Operational risk covers a wide range of risk including human factor risk and liquidity risk (Crouhy et al 2001), The consequences of each of the risks affecting the project should be analyzed and evaluated. Businesses always have a choice of projects they want to invest in. Projects that have a high risk of failure should be avoided in favour of those with lower risk. This scenario is illustrated in the matrix in the Appendix. The information indicates that where the probability of risk is high and the impact of the project on the business would be catastrophic, it should be avoided. However, losses from a project can be controlled. The risk of losses can be controlled by taking the steps necessary to reduce them. Some of these steps are ensuring there is enough cash resources to make loan and interest payments. This is necessary when the specific project does not create enough cash flows (Ct) to cover them. This includes preparing cash budgets that are reviewed on a regular basis to determine whether adjustments are necessary. The financial controller should ensure that expenses are prioritised in order to prevent liquidity crisis or insolvency. Only items that are critical to the success of the business should be given high priority. This will prevent the business from incurring penalties for making late payments. It will also make it easier for the business to obtain additional loans at more favourable interest rates in the future. Effective risk control procedures can facilitate successful project management and risk reduction in future as creditors will be more willing to lend to the business. This will facilitate more projects in the future at lower cost of capital (k).When k is low projects are more likely to have a positive NPV. A lower k can turn a project with a negative NPV into one with a positive NPV. A good credit rating will also help the company obtain loans from other lenders at even more favourable rates. Financial institutions will also be willing to offer loans without requests from clients. 2.1.4 Risk avoidance Risk avoidance is a risk management technique that seeks to eliminate any possibility of risk by preventing its occurrence. It is typical for business not to undertake an activity in this scenario (Alexander and Marshall 2006). Risks that will have a catastrophic impact on the business should be avoided. This is necessary when the probability of failure is high. Accepting projects with positive cash flows by performing sensitivity analysis and calculating expected values using project evaluation and review technique (PERT) is one method that the manager can use to determine whether to accept a project. PERT analysis considers optimistic, pessimistic and most likely cash flows to arrive at the expected or a best estimate of the cash flows from a project. Probabilities can also be attached to different levels of cash flows in order to arrive at a more realistic estimate. Risks can also be avoided in the case of projects with foreign currency inflows. The loans to finance the initial investment (I) on such projects could be borrowed in the relevant currency. If the interest rate is lower then k would be reduced. Since k is one of the main risk elements this would have a positive impact on NPV. This is also a hedging strategy that should be given serious consideration. Some projects are shrouded with uncertainty and the risks of carrying through with them should be avoided as a slight change in any of the components of Ct and k could have serious consequences. They may be considered some time in the future when the opportunity arises. 3.0 Practical suggestions for estimating realistic values for Ct, k and l Realistic values of Ct, k and I are important in evaluating projects. Estimates should be based on the realities affecting the specific project. Efforts should be made to ensure that cash flows (Ct) are calculated on different bases to arrive at a reasonable estimate for the duration of the project. All relevant costs associated with the project should also be included. In terms of a reasonable cost of capital (k), the method of financing the project should be used instead of one that is based on the organizations weighted cost of capital. This would be more realistic as it relates specifically to the project. Therefore, if equity is used the cost of capital (k) should be equal to the cost of equity (re). If debt is used then k should be equal to rd(1-T). If a combination of debt and equity is used then the relevant proportions should be used in calculating WACC which is the cost of capital (k) for the project. The formula for calculating WACC is: WACC = We * re + Wd *rd(1-T) In the formula We represents the weight of equity and Wd, the weight or proportion of debt in the business. The other elements were described previously. If debt and shares are issued publicly to fund the project then flotation costs are involved. This cost should be taken into consideration in arriving at k. A realistic value for I is not just the funds invested but the flotation cost of obtaining debt and equity where this is involved. It is important that any such costs are taken into account so as to have a more realistic picture of project costs. If these are not included then the whole process of deciding whether the project should be accepted would be flawed. A realistic estimate of NPV can only be ascertained if Ct, k and I are realistic. Calculating NPV using realistic figures can be cumbersome at times but it needs to be done to ensure that liquidity problems do not arise. Failure to include realistic estimates may result in losses on projects that were initially thought to have positive NPV’s. 4.0 Conclusion Realistic estimates and risk assessment strategies are very critical to the NPV project appraisal technique. The implications of not using realistic estimates could render the failure of what was previously considered very profitable projects. The proper risk assessment strategies are required to ensure that risks are reduced, transferred or avoided where they are considered as being too high. Risks should only be retained on projects which have a low probability of failure and a low business impact. The risks on a project with a low probability of failure and for which the business impact is high should be transferred to a third party. Projects with high probability of failure and high business impact should be avoided. References Brigham, E.F and Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. Mason, Ohio: Thomson South-Western. Crouhy, M., Galai, D and Mark, R. (2001). Risk Management. USA: McGraw-Hill Education (Australia) Pty Ltd Heaton, J.B. Managerial Optimism and Corporate Finance. Financial Management, 31(2), p. 33 – 45. Kallman, J. (n.d.). RM101: Financing Risk Retention. Available at: http://cf.rims.org/Magazine/PrintTemplate.cfm?AID=3755 Titman, S., Keown, A.J and Martin, J.D. (2013). Financial Management: Principles and Applications. 12th ed. USA: Pearson/ Prentice Hall Alexander, C and Marshall, M.I. (2006). The Risk Matrix: Illustrating the Importance of Risk Management Strategies. Journal of Extension, 44(2). Available at: http://www.joe.org/joe/2006april/tt1p.shtml Appendix Risk Matrix Adapted from Alexander and Marshall (2006) with adjustments Read More