The Significance of the Components of NPV for Corporate Risk Management Decisions - Essay Example

The Significance of the Components of NPV for Corporate Risk Management Decisions 0 Introduction According to Akintoyeand MacLeod (1991) many organizations have recognised the importance of risk management. The components of NPV are very critical to corporate risk management decisions. This paper looks takes that into consideration and looks at the process by which the NPV appraisal technique determines whether a project should be accepted or rejected. It then looks at the components of the NPV equation in relation to corporate risk management decisions. It does so by looking at the real world components of net free cash flows (Ct), the capital investment in the project (I) and the cost of capital or discount factor (k). The components of Ct, k and I are used to evaluate risk management activities such as risk retention, risk transfer, risk control and risk avoidance at NPV. 2.0 Net Present Value (NPV) Net present value (NPV) one of the most popular investment appraisal techniques. In fact Kaplan (2013) indicates that it is the best technique for evaluating capital investment projects. In making the decision of whether a project is viable, NPV takes into consideration the time value of money and the maximization of shareholders wealth (Titman et al 2011). This is done by discounting the relevant cash flows. The relevant cash flow is the free cash flow that the particular project generates (Kaplan 2013). The formula for calculating NPV is given as: n Ct NPV =  - I t=1 (1+k)t The formula indicates that the NPV is equal to the sum of the annual free cash flows (Ct) for the duration of the project, represented by t = 1 to n periods. The initial capital outlay (I) is the amount of capital invested in the project. The cost of capital is represented by k. It is the same as the weighted average cost of capital (WACC). It uses the relative portions or weights of the sources of finance to obtain an average rate. This rate is used as an estimate of the cost of capital (k). This rate (k) is used to discount the annual net cash flows to present value. The cost of capital (k) takes into consideration the inflation rate and the real interest rate. 2.1 The Decision Rule for NPV A company evaluates the expected future cash flows in relation to the required initial investment when evaluating projects (Emery et al 2007). The decision rule for NPV is to accept the project if the NPV is positive and reject the project if the NPV is negative. The cost of capital (k), the discount factor is critical to this decision as one rate may result in positive NPV while another rate results in a negative NPV. The uncertainty in relation to cash flow is critical as any significant fluctuations could result in major losses. The way in which the initial capital outlay is funded will also have a significant impact on the project. 2.2 Real world components of Ct, k and I The real world components of Ct, k and I are very important for corporate risk management decisions. These variables present different levels of risk on the basis of how they are made up. The uncertainties associated with Ct are dependent on its components. In the same manner the components of k will determine the level of risk borne by an organization and its shareholders. There is some interrelationship between k and I and so the manner in which funding is generated for the project will determine k and its associated risks. 2.2.1 Components of net free cash flows The components of Ct are the revenues from the project and the operational expenses associated with the project. The risk associated with revenues is that there is no certainty that the amount generated will be the same as planned. Several factors including foreign exchange fluctuations, delays in receiving income, and general price changes can affect projects negatively. Delays in starting the project may also occur. These risks can be addressed by using various risk management strategies. 2.2.2 Components of the cost of capital The components of k vary depending on the capital structure of the company and how the project is financed. The proportions of debt and equity in the capital structure and how the project will be funded will determine the relevant k. 2.2.3 Components of the Initial Capital Outlay The initial investment in the project can come from debt only, equity only or a combination of both. The source of capital will have an impact on the capital structure and therefore the level of gearing. The level of gearing that the company wants to maintain as part of its long term strategy will also determine how capital projects are funded. Gearing is concerned with the long term capital structure of a company (BPP 2009). Companies normally try to maintain a certain level of gearing in order to keep financial risk at a minimal level. If the capital structure contains too much debt relative to equity then the company will have a high level of gearing. There is no guideline in relation to the acceptable limit. However, a company with a gearing ratio of over 50% is considered to be highly geared (BPP 2009). Third parties including banks and other lenders have an interest in a company’s level of gearing. This and other debt related ratios will be used to determine the level of financial risk and therefore the interest rate charged on loans. The level of gearing and the long term strategy of the company will also determine how capital projects are funded. 3.0 Using Components of Ct, k and I to evaluate risk management activities at NPV In making a decision on how to finance a project management considers the risk associated with Ct including revenue shortfalls, untimely receipts and unexpected increases in expenses. Consideration is also given to how to finance the project – debt or equity, or a mixture of both. The components of k and I – equity, debt and the interest rates associated with them will be used in the evaluation of the risk management activities at NPV. 3.1 Risk management activities Risk management strategies are used to determine the decision a company should take based on the components of Ct, k and I. The strategy employed depends on the relevant component of Ct, k and I. Different components will require different treatment. A risk matrix can be used to assess risk and to provide information on how to treat with different risk management activities. Figure: Risk Matrix The risk matrix shows the four risk management activities for which Ct, I and I are evaluated at NPV. If the probability of risk is low and the impact on the business is low then risk should be retained. In terms of transferring risk, this can be done if the business impact of the project is high but the probability of failure is high. Risk should be avoided when both the probability of failure and the impact on the business is high. Risk should be controlled if the probability of failure is high and the impact on the business is low. 3.1.1 Risk retention strategies Risk retention strategies include financing the project using equity in the form of retained profit or a share issue. In this way the risk associated with the project and the overall risk of the company would be lower since no debt would be used. If retained profit is used to finance the project then there would be no cash inflow towards the project. However, if a share issue was involved then there would be an inflow of new funds associated with I. The risk associated with using retained profits relates to liquidity. If the risks associated with cash flows (Ct) including: untimely receipt of income, fluctuations in exchange rate and unexpected price increases are high then risk retention is not recommended as NPV would most likely be negative. However, if income is received in a timely manner, and prices remain fairly stable with no fluctuation in the exchange rate then retention is encouraged. The reason for this recommendation is that NPV would be closer to the estimate calculated at the appraisal stage and so would most likely remain positive. In terms of cost of capital (k), the source of funds as well as the level of k would be a determinant for or against risk retention. A high cost of capital would not merit risk retention. However, a low k would certainly do. 3.1.2 Risk transfer strategies Risk transfer strategies relating to Ct are considered when any of the following occurs thus rendering projections useless. Fluctuations or uncertainty with revenue from the project Possibility of catastrophic occurrences such as fire, burglary and flooding Possible increase in prices due to general and specific inflation Exchange rate changes Fluctuations or uncertainty in revenue streams can occur due to political and economic factors. In this scenario risk should be transferred by insuring the project. The same treatment applies to catastrophic occurrences. In the case where prices are expected to increase, hedging against such changes by buying goods at the spot price is recommended. Hedging strategies can also be employed against exchange rate fluctuations. This is required when goods are sold at set prices to foreign customers. Two very popular methods of hedging against exchange rate changes are forward contracts and futures contracts. In a forward contract the price is agreed at the date of the contract for settlement at a specific date in the future. This strategy required the company to deliver foreign exchange on that date. The rate agreed will be paid. This may or may not transfer all the risk but is definitely better than doing nothing. In the case of futures contracts where foreign currency will be sold, the process is referred to as short hedge. The company will sell currency in a futures contract. This protects the company’s cash inflows from fluctuating due to changes in the rate of exchange. Once the strategies are effective risk will be transferred to a third party and the impact on NPV will be minimal. 3.1.3 Risk avoidance strategies Avoiding risk is a very popular strategy that seeks to eliminate risk by not undertaking a project. Projects with negative NPV should be avoided and should only be considered when the components of k change sufficiently to make them viable. Projects for which k is high should only be undertaken after evaluating the probabilities of low, high and normal cash flows. There various ways in which risks relating to fluctuations in cash flows as result of foreign exchange rate changes can be avoided. One method is to source financing for the project in the currency in which most if not all of the revenues from the project will be generated. The receipts from the project will then be used to make loan and interest payments. If the only source of financing available to a company is debt and the company is highly geared then risk avoidance should be employed. The company should not embark on a project which will significantly affect its liquidity. Doing otherwise may lead to inability to make principal and interest payments on the loan. This may force lenders to place the company in receivership to recover their debts. 3.1.4 Risk control strategies Risk control strategies involve analysing the components of Ct, k and I. Cash flows (Ct) can be analysed for political risk, operational risk, and exchange rate risk. Operational risk is defined as the loss resulting from failed processes, external events human and systems (Girling 2013).Operational risks arise from fraud, disasters and non-deliberate actions (Allen 2013) The consequences of each of the risks affecting the project should be analyzed and evaluated. It is the only means by which adequate measures can be put in place to prevent or reduce losses. The risk matrix provides information on when projects should be avoided. Despite the challenges associated with projects the risk of failure can be controlled by preparing budgets, reviewing them regularly and making adjustments where necessary 4.0 Suggestions for determining a realistic estimate of Ct, k and l Realistic values of Ct, k and I are critical in the evaluation of projects. Estimates should be project related instead of company related. This specifically applies to k where company related WACC is often used. Kaplan (2013) recommends a cost of capital that specifically relates to the project. 4.1 Realistic Cash flows Realistic cash flows (Ct) are important in calculating NPV. If cash flows are high but unrealistic and results in positive NPV then the decision will be taken to accept the project. However, if the cash flow is low but realistic and the result is negative NPV then the project will be rejected. This means that reliable estimation methods should be employed in estimating cash flows. 4.2 Realistic cost of capital (k) The company will be better able to assess the outcome of the project if the actual cost of capital is used. Therefore, if two sources were used then the use of WACC based on the cost of debt and equity and the relevant proportions of each would be appropriate. The formula for WACC is: WACC = E/(D+E)re + D/(D+E) (1-T)rd = (1-L)re + L(1-T)rd In the formula E is shareholders’ equity, D - debt, T – the tax rate, L - leverage or gearing, and re – the cost of equity. Several methods exist for calculating the cost of equity. The CAPM is the most popular and realistic approach. This method takes into consideration several interest rates several variables including the company’s beta and the risk free interest rate. 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 being appraised. Therefore, if only equity is used k should be equal to: re (k) = rRF +b (RPM) In the formula, the cost of equity is represented by re, rRF -the risk free rate of interest, b – beta, and RPM - the risk premium. If only debt is used then the formula is : Cost of capital (k) = rd(1-T). In the formula above rd is the cost of debt and T – the tax rate. 4.3 Realistic capital outlay Realistic capital outlays (I) will not be used if certain funds are not included. If shares or debt is issued to the public then the cost of the issue should be taken into consideration as part of the capital outlay (I) on the project. Including these costs will result in more realistic estimates of project costs. Ignoring these costs where they exist will indicate NPV’s that suggests project acceptance when this may not actually be realistic. 5.0 Conclusion The real world components Ct, k and I are critical to corporate risk management decisions. Failure to find realistic estimates of them can lead to the acceptance of projects that should be rejected and in some cases the rejection of projects that should be accepted. To avoid this problem realistic estimate of Ct, k and I taking into consideration the specifics of the project is necessary. Using a discount rate (k) that is specific to the project is critical factor. The cost associated with issuing debt and equity should always be included in the cost of the project whenever they are applicable. Additionally, the strategies of risk retention, transfer, avoidance and control should be applied where necessary. These will help to significantly reduce the risk of losses. References Akintoye, A.S and Macleod, M.L. (1997). Risk Analysis and management in Construction. International Journal of Project Management, 15(1), p. 31 - 38 Allen, S. (2013). Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk. 2nd ed. Hoboken, NJ: John Wiley & Sons, Inc BPP Learning Media (2009) Paper F7 Financial Reporting. 3rd ed. Aldine Place, London: BPP Learning Media Ltd Emery, D.R., Finnerty, J.D and Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall… Girling, P.X. (2013). Operational Risk Management: A Complete Guide to a Successful Operational Risk Framework. Hoboken, NJ: John Wiley & Sons Kaplan Publishing. (2013). ACCA P4 Advanced Financial Management: Essential Text. Wokingham: Berkshire. Kaplan Publishing Titman, S., Keown, A.J and Martin, J.D. (2011). Financial Management: Principles and Applications. 11th ed. USA: Pearson/ Prentice Hall Read More