Risk Management Decisions - Assignment Example

Risk Management Decisions Institute Risk Management Decisions a) What are the key risk management decisions? Risk management is a complicated process and greatly depends on the firms specific requirements and goals. If a firm is seeking to invest in a project it needs a specialist in financial analysis to be able to accurately weigh the costs against the benefits. Moreover, the financial manager needs to consider the risks associated with this investment. There are plenty of tools available for risk managers to assess and manage the risks. But it is not up to the risk manager to solely base the decision on cost-benefit analysis. Risk managers also need to incorporate the companys vision and mission into their technique to be able to reach defined goals. This way they are better shaped to maximize the wealth of the shareholders, which is the ultimate goal of any firm. Fusing risk analysis and decision-making brings together the areas of economics, decision analysis, management sciences, mathematics and statistics. Hence, the better term to the person in charge is managing financial risk. Decision analysis, risk management and quantitative finance are some of the tools that the risk managers are equipped with in coping financial risks. Decision trees give a clear picture how cash flows unfold over time, they are useful in deciding what risks should be avoided and which one taken (in pursuit of benefits) (Damodaran, 2011). For instance, a decision tree of an asset would reveal where the worst case scenario unfolds. If it is a financial asset it can be hedged against the risk of dollar-Euro fluctuation. Profit and loss are the primary drivers that the risk management needs to consider. In other words the key risk management decision has to do with the time value of money. The time value of capital investment is calculated through two methods, the NPV and the IRR. One of the key risk management decision is determined by calculating the Net Present Value or NPV of a project/firm. It is determined by comparing the present value of all cash inflows with the cost of the investment proposal (Schmidgall, 2003). The simplest rule of the NPV is one must disregard the projects with negative NPVs and undertake the ones with positive NPVs (Ross, 1995). The risk managers sometimes face a dilemma regarding projects with positive NPVs. They have to investigate deeper if they want to reach accurate conclusions about an investment. If the capital markets are efficient the securities of the firm making these investments will obviously show the positive value of those projects (Moyer, McGuigan, Rao & Kretlow, 2011). NPV offers its unique pros and cons. The Net Present Value is one of the more useful tools for summarizing the profitability of an investment (Bierman, 2010). The net present value for project represents the expected number of dollars that the present value of the firm if increased by when they undertake the project. The NPV method is consistent with the goals of the shareholders’ wealth maximization. This approach considers both the magnitude and the timing of cash flows over the expected life of the project. The firm represents the series of projects and company’s total worth as the sum of the net present values of all the independent projects that it undertakes (Moyer, McGuigan, Rao & Kretlow, 2011). Hence, when a company undertakes a new project its value increases by the net present value of the new project. This edition of net present values of independent projects is known in the finance world as the value additivity principal. The net present value approach indicates if a proposed project yields the rate of return that the firms investors require. This cost of capital represents the rate of return, in other words, when the projects net present value is greater than or equal to zero the investors can expect to earn at least their investments equivalent (Moyer, McGuigan, Rao & Kretlow, 2011). The net present value criterion has a flaw that many people find it difficult to work with present value dollar return compared to the percentage return (Moyer, McGuigan, Rao & Kretlow, 2011). Hence, many companies use other methods that interpret more easily such as the internal rate of return IRR method. Moreover, the net present value approach does not consider the real options of the value that constitute the proposed project. b) What are the direct costs and benefits of these decisions and how might they be estimated? The efficiency of financial management (eventually the risk management) is determined by the success in achieving the firm’s goals (Dayananda, 2002). In other words the management should strive to maximize the net present value of expected future cash flows to the shareholders’ firm (Dayananda, 2002). The direct cost of risk management decision is the time value of money. Today the value of money is more than the value of the same amount tomorrow. The assumption with the NPV (and IRR) method is that cash flows are assumed to occur at the end of each period (Jackson, Sawyers & Jenkins, 2008). The direct costs are not that simple to calculate and base decisions on. For instance, two project A and B might return their NPVs, where A’s NPV is greater than B’s. It does not mean that A is more profitable than B considering the time value. The best way to resolve this dilemma is to see which project returns the most profit on per dollar investment (Warren, Reeve and Duchac, 2008). To estimate the NPV, the following five steps are involved (Albrecht, Stice, Stice & Swain, 2007); 1) Estimating the amount and timing of cash flows 2) Evaluating the riskiness of cash flows to determine the discount rate 3) Computing the present value of all expected cash flows (inflows and outflows) 4) Subtracting the present value of cash outflows from total present value of cash inflows 5) Deciding whether to undertake or reject the investment If the project is social (public sector investments) a slightly different version of NPV is used, the social net present value (SNPV); the marginal social benefits and costs are discounted back to the present using an appropriate social discount rate (Hirschey, 2008). This version of NPV has limited usage. Only listing potential benefits that are derived anecdotally would not suffice undertaking a project. It is desired to perform some kind of cost-benefit analysis for risk management of the project. This can be carried out at two levels: long-term and short-term. Process, education, application and culture are the major items that go beyond the traditional cost-benefit analysis. They indicate the types of investments and organization must make. The risk management staff considers implementing cost-benefit analysis on a project to reject or undertake it. Broader benefits can also be obtained by putting the project through this rigorous test; Short-term cost-benefit analysis Costs Providing risk infrastructure (tools training etc.) Providing resources for the risk process Implementing the Action Course for Managing Risk Benefits Improved predictability of project Successful delivery of the project Enhanced customer experience Long-term cost benefits analysis Costs Commitment Consistency Continuation Culture Benefits Growth of Business Motivation of Team Increased Contingency Plans Improved Reputation The common expectation is that the degree of benefits will exceed the costs. This is enough evidence suggesting a prudent justification for the use of risk management and projects is an efficient approach for dealing with intrinsic uncertainties. If such costs and benefits are measured and reported consistently they will empower the risk managers within a business for supporting the use of risk management in their projects so they can better sell it to the executives. c) What are the indirect costs and benefits and how might they be estimated? The area of considering the indirect costs and benefits of the project is very broad. There is no one-size-fits-all solution for a project. The task is to weigh costs and benefits, which is highly customized and depends on the situation of the company, the investment, the timing, the political scenario and many other factors. The trade-off model for capital structure becomes irrelevant in a world that doesnt have any taxes or market frictions. In addition the angle or the perspective of analyzing the costs and benefits of long term and short-term depends on the corporate or the person investing in the project. For instance, there is a difference between the interests of the firm and that of the shareholder. There are differences that relate to the time perspective. The long-term interest of the firm are obviously long-term but the shareholders have a different view for their long-term benefit. Shareholders have interests ranging from extremely short-term interests such as the day traders of enlisted companies to long-term interests of family shareholders. Secondly, shareholders can get benefits indirectly as residual claimants and directly as private benefits. The benefits that shareholders obtain directly do not have to be shared with any other shareholder or the firm. From the shareholders perspective there is a trade-off between direct and indirect benefits. Private or direct benefits "can be beneficial neutral or harmful to the firm" (Mantyssari, 2009, p. 218). In case they are harmful to the company they might reduce the indirect benefits. Shareholders can extract direct benefits until the marginal direct benefits correspond to his share of marginal indirect costs. The shareholders will not be put off by harms sustained by the firm. If their direct private benefits outweigh the firm’s, the shareholders get more indirect share of the damage. The loss that the company suffers can be larger than the shareholders share of the loss even if the shareholder owns only a small chunk of shares. Similarly the indirect and direct benefits are likely to be lower for the shareholders. As explained earlier, the direct and indirect costs vary from project to project. To give an example of how direct and indirect costs appear and how risk managers deal with them consider the following example given in the book Economic valuation and policy priorities for sustainable management of coral reefs (2004). An island is located in the South Central Indonesian archipelago between Bali and Sunbawa. Its population depends on the island’s coastal resources. Tourism is also an important industry here and so is fishing and mangrove forestry. Coral mining is a small-scale industry but there are costs related with this profession. To evaluate this project all costs are calculated in NPV for a term of 30 years. The net present value shows the discounted sum of annual costs over this lifetime of the project. The net loss of the fishery function is also valued in it. The indirect costs of undertaking this project would mean that tourism will be affected (Ahmed, Chong, & Cesar. 2004). Moreover the coastal protection will also needs funding (Ahmed, Chong, & Cesar. 2004). Just to give an example of what direct and indirect costs and benefits of the project might look like. The direct costs of undertaking this project would involve labor, wood, site payments and other costs. The direct benefits would be the sales of lime and the site payments. Similarly the indirect costs would include coastal erosion, increasing wood prices and other functions (Ahmed, Chong, & Cesar. 2004). The opportunity costs would include foregoing tourism, the net loss of fishery, the labor costs and the costs to minors. It is for this reason when the net present value is calculated it has two different figures. There is an economic net present value and then there is the financial net present value (Ahmed, Chong, & Cesar. 2004). The risk managers might spend days in calculating the NPV. The job is not a simple calculation of present values of cash flows. There are other costs to consider as well. Risk managers specialize in different fields. Some are experts in agricultural investments, while others specialize in chemicals, and then there are those that learn the craft of financial risk management. This paper mainly covered the financial risk management side of decision making. The primary decision a risk manager makes is whether to accept or reject a project. To reach this conclusion, NPV of the project is determined. Costs and benefit analysis defines the profitability and the ultimate decision of undertaking the project. The NPV method offers its unique drawbacks but due to its wide applicability it is the most popular tool of risk managers for assessing a risk. References 1. Ahmed, M., Chong, C. K. & Cesar, H. 2004. Economic valuation and policy priorities for sustainable management of coral reefs. WolrdFish Inc. 2. Albrecht, W., Stice, J. Stice, E. & Swain, M. 2007. Accounting: Concepts and Applications. Cengage Learning. 3. Bierman, H. 2010. An Introduction to Accounting and Managerial Finance: A Merger Equals. World Scientific. 4. Damodaran, A. 2011. Applied Corporate Finance. John Wiley & Sons. 5. Dayananda, D. 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. 6. Hirschey, M. 2008. Fundamentals of Managerial Economics. Cengage Learning. 7. Hillson, D. 2012. Managing Risk in Projects. Gower Publishing. 8. Jackson, S., Sawyers, R. & Jenkins, G. 2008. Managerial Accounting: A Focus on Ethical Decision Making. Cengage Learning. 9. Mantyssari, P. 2009. The Law of Corporate Finance: General Principles and EU Law: Volume I: Cash Flow, Risk, Agency, Information. Springer Science & Business Media. 10. Moyer, R. C. McGuigan, J. Rao, R. and Kretlow, W. 2011. Contemporary Financial Management. Cengage Learning. 11. Ross, S. A. 1995. Uses, Abuses and the Alternatives to the Net Present Value Rule. Financial Management. Vol. 24(3). 96-102. 12. Schmidgall, R. S. 2003. Superintendent’s handbook of financial management. John Wiley & Sons. 13. Warren, C., Reeve, J. and Duchac, J. 2008. Managerial Accounting. Cengage Learning. Read More