The Approaches a Non Financial Company - Essay Example

Critically discuss the approaches a non-financial company should take in defining, measuring and effectively managing the risks inherent in a potential new project Table of Contents Definition and measurement of risk 3 Managing Risk 6 Conclusion 9 Reference 10 Bibliography 12 Introduction Risk is the part and parcel of every business. A company carries out its activities based on an anticipation of the future trends. There is a possibility that the outcome in the future may not match with its anticipation but still the company pre-plans its operations. The probability of the mismatch between the expected and the actual outcome is the risk. It can result in financial losses. But still risk is an inevitable part of every business. The risk for a new project includes the non-availability of funds, unrealized debtors, availability of suppliers, availability of buyers, increase in the estimated expenditure, foreign currency risk, etc. Definition and measurement of risk The company plans its operations well in advance. These plans are based on an analysis of past activities and estimated forecasts. When the actual result matches with the planned result there is a gain but when the actual outcome is different from the expectation there is a loss. Despite this the activities of the company are based on the forecasts. This means that the company is taking a risk. Suppose, there is a company X Ltd based in US. A research by the company reveals that there is a good market for its product in Canada. To tap the Canadian market the company wishes to start its operations in Canada. For a new project the company requires funds for buying equipments, employing man-power, procuring materials etc. The funds required for setting up its new operations can be obtained as loans from financial institutions. But the availability of loan depends on the market conditions. It is difficult to obtain loan in a tight monetary market. During these times the company has to pay a high rate of interest for securing loans. This raises the interest obligations of the company. Moreover the company is also subject to the risk of interest rate fluctuations. This is called interest rate risk. If the company avails a floating rate loan, a rise in the rate of interest pushes up its interest cost. This can be hedged with the help of swaps and derivative instruments (Nawalkha et al, 2005, P1). The material constitutes the most important part of the input. Its non-availability can have an adverse impact on production levels. If the company relies on a single supplier then it can be exposed to the unjust demands of the supplier. This can give rise to instances of short-supply, unfair prices etc. On account of his supreme position, he can demand for unfavourable terms of credit. If the supplier has a monopolistic position in the market he can ask for higher prices for the material. This can exert a pressure on the earnings of the company. If the company is new in the business it will not be able to pass on the rise in the input cost to the consumers. When a company starts a new project it has to face competition from the existing market players. Often the new products fail to attract the customers. It is difficult to make the customers switch their preferences. Moreover the strong market presence of the rival thwarts the entry of new players in the industry. In such a situation it becomes increasingly difficult for the new players to establish themselves in the industry. Besides the risk of market rivals, X Ltd also has to face the currency risk. As the receivables and the payables of the Canadian operations of the company are denoted in terms of the foreign currency, it has to continually face the risk of exchange rate fluctuations. To avoid this company can denominate its receivable and payables in the domestic currency but this is not always feasible (Shoup, 1998, P79). If the value of foreign currency appreciates against the domestic currency then the value of foreign currency payment increases. Due to this the company has to spend more US dollars for honouring its foreign obligations. Similarly, the value of its foreign currency receivables depreciates if there is a depreciation of the foreign currency against the domestic currency. This will reduce the earning of the company and add to the currency loss. The new project may require the company to use new technology. Often the employees find it difficult to adapt to any new software. This not just reduces the productivity but also makes them demotivated. The company generally accepts a project based on a forecast of the future cash flows. Based on the initial, operating and terminal flow of the project, the net present value is calculated. If the NPV of the project is high it is selected. But the entire process is based on assumptions. It may happen that the credit sale may turn to be bad thus lowering the cash inflow. So there is always an element of uncertainty associated with the cash flows. The cash outflows budgeted by the management may exceed the estimated figures. This can considerably impact the profitability of the project. If the manufacturing process adopted by the company is not environmental friendly then it will hamper its social image. The customer base of a company depends on the market reputation of the company. If the company fails to satisfy its social responsibilities it can have a negative impact on its revenues. Besides this the government imposes levies on the activities that cause harm to the society. The political factors play a major role in the business operations of the company. Often the political uncertainties can significantly impact the business operations. Suppose if the government of Canada bans the import of an essential input then the company will face difficulty in production. Managing Risk Risk is an inevitable part of the business. With the advancement in the modern markets various hedging tools have been designed. The company’s attitude to the risk can be neutral or averse. If the company is risk neutral it may not consider the hedging actions to be necessary. This is true if the company has insignificant amount of exposure. However for the company that is risk averse can hedge its exposure with the help of various over-the counter and exchange traded derivatives. An adverse movement in the exchange rate can have a serious bearing on the cash flows as well as the profitability of the project (Coyle, 2000, P15). The risk associated with funds can be removed by tapping the capital markets. Besides this the company can take loans from the financial institutions. Nowadays the banks provide financial assistance to small and medium enterprises at reasonable rates for the growth of the industry. These loans are available on favourable terms and can be paid in easy instalments. Apart from loans the company can tap the equity market. It can raise money by offering its shares to the public. Alternatively it can opt for rights issue. In a rights issue, the company offers its shares to the existing shareholders. By issuing shares it transfers a percentage of ownership to the public. This does not give rise to any fixed obligations as the shareholders are paid in the form of dividends. Unlike interest payments the declaration of dividend is not mandatory for the company. So it does not create a financial burden on the company. In fact the interest payments on the loans are subject to interest rate fluctuations. Any unfavourable change in the rate of interest is not good for the financial health of the company. With the advancement in the financial markets various instruments have been designed that can take care of the interest rate risk. These include swaps, Forward rate agreement (FRA), interest rate cap and floors etc. Swaps are financial instruments that involve an exchange of a stream of cash flows between the contracting parties. The companies worldwide use swaps for managing the interest rate and currency risk for lowering the probability of losses (Bodie, Merton, 2002). Suppose the company has a floating rate loan and is afraid of interest rates moving up. For avoiding the high interest burden the company can enter into a swap. It can enter as fixed rate payer with the other party agreeing to pay the floating rate. By way of this the company can lock a fixed rate on its loan. A rise in the rate of interest will be compensated by the floating receipts under the swap arrangement (Ludwig, 1993). The company can also use FRA for securing its position in the loan market. It involves an agreement regarding the exchange of cash flows at a specified future date (Hunt, Kennedy, 2004, P229). If the company plans to start the project after say six months and is afraid that the interest rates will move up in the coming six months then it can buy a six month FRA. By way of this agreement even if the interest rate moves up after six months the company can avail the loan at the agreed upon rate in the FRA contract. This will protect the company from the risk of high interest payments. For hedging the long term loans the company can use the interest rate caps by paying an upfront premium. If the interest rate exceeds the cap rate, the company is compensated by the excess of rate over the ceiling specified in the interest rate cap agreement (Madura, 2008, P416). The company can keep the value of its overseas cash flows intact by using currency options. Currency options are of two types- call option and put option. Call option gives the right to buy the currency at an agreed upon exchange rate on or before the date of maturity of the option. Similarly the put option gives the right to sell the currency at a rate agreed upon today, on or before the date of maturity of the option (Madura, 2008, P126). The company can keep the value of its receivables in Canadian dollars intact by buying the put option on the currency. This will give the company the right to sell Canadian dollars at the strike rate in the option contract irrespective of the market movements. Similarly, for hedging its payables in Canadian dollars the company can buy call option that will give it the right to buy the foreign currency at the agreed upon rate. To avoid the unjust demands of the supplier the company must procure its materials from more than one source. This will protect the company from any undue reliance on any particular supplier and negotiate reasonable prices for the material. For tackling the risk from the existing competitors the company can organize extensive advertisement campaigns. This will generate awareness about the company in the market. It will facilitate its market entry and enable it to establish itself. For handling the risk related to the cash flows the company must be careful while extending credit to the buyers. It must scrutinize the credit history of the customer before advancing goods on credit. This will help in lowering the default risk. Often the actual expenses may not match with the forecasted figures. In order to tackle such emergencies, the company can maintain Contingency funds that can be used if thee is an unforeseen rise in the expenditure. To avoid reliance on any particular market segment the company can diversify its market base by catering to various markets. This will ensure a smooth flow of revenue for the business. Often the actual results of the project may not match with the forecasts, there may be surprises. For handling this, the company must keep its strategies in place ((Tinnirello, 2002). Conclusion A risky project should be undertaken by the company only if it adds value to the investment. The return offered by a risky investment must be higher than similar projects (Brealey et al, 2007). Risk can be quantitative as well as qualitative. While the quantitative risk can be handled using hedging tools, for mitigating the qualitative risk factors like risk of market competition the company must devise suitable strategies. Considering the complexity associated with risk management the companies maintain a department that is in charge of handling the risks of the business. The main task of risk management is to defer the risk indefinitely making it a routine affair and not a one time process. Reference Bodie, Z. Merton, C.R. 2002. Abstract. International pension swaps. Available at: http://www.people.hbs.edu/rmerton/internationalpensionswaps.pdf [Accessed on January 29, 2010]. Brealey, A.R. Myers, C.S. Allen, F. Mohanty, P. 2007. Principles of corporate finance. Tata McGraw-Hill. Coyle, B. 2000. Hedging currency exposures. Lessons Professional Publishing. Hunt, J.P. Kennedy, E.J. 2004. Financial derivatives in theory and practice. John Wiley and Sons. Ludwig, S.M. 1993. Understanding interest rate swaps. McGraw-Hill Professional. Madura, J. 2008. Financial markets and institutions. Cengage Learning. Madura, J. 2008. International Financial Management. Cengage Learning. Nawalkha, K.S. Soto, M.G. Beliaeva, A.N. 2005. Interest rate risk modeling: the fixed income valuation course. John Wiley and Sons. Shoup, G. 1998. Currency risk management: a handbook for financial managers, brokers, and their consultants. Lessons Professional Publishing. Tinnirello, C.P. 2002. New directions in project management. CRC Press. Bibliography Fabozzi, J.F. 1998. Perspectives on interest rate risk management for money managers and traders. John Wiley and Sons. Francais, A. 2006. OECD Economics Glossary English-French. OECD Publishing. Jorion, P. 2007. Financial Risk Manager Handbook. John Wiley and Sons. Marshall, F.J. Kapner, R.K. 1993. Understanding swaps. John Wiley and Sons. Taleb, N. 1997. Dynamic hedging: managing vanilla and exotic options. John Wiley and Sons. Read More