Investors have the task of enhancing investment value on a sustainable basis. Important to long-term performance are growth portfolio and profitability. As operations continue generation of funds through accrued profits and increased capability of raising more capital from shareholders, investors and lending institutions require careful management to increase stakeholder value. Simultaneously, numerous opportunities present themselves for capital investment. To determine the best alternative, financial procedures offer important tools for decision-making. This report discusses some of the salient tools for capital budgeting including Net Present Value and Discounted Cash Flow. The report then highlights the types and importance of risk as well as how net present value is used in determining project viability.
Risk and risk preference
There are various types of risks therefore directors are right by mentioning systematic risks and unsystematic risks and total risks. Each form, of risk, has some characteristics except the total risk which is a combination of the systematic and unsystematic (Pandey, 2008)
Systematic risks can be defined as the risk which is a result of economic uncertainties and the tendency of stocks in a portfolio to take a trend similar to the market trend. This form of risk cannot be easily reduced by diversification or ordinary portfolio management techniques because it is market risk. Investors in the market incur the brand of this risk even if they have a very well-diversified portfolio. As it were portfolio diversification reduces risk but this form of risk cannot be diversified by ordinary management but can be managed by monetary and fiscal policies of the government. Examples of systematic risks include the government interest rate policy, corporation tax, government deficit financing strategies, foreign exchange controls, capital gain tax rates, credit policy management, inflation rates that are prevailing in the market, and many others. Systematic risks can be grouped into various categories such as market risk, purchasing power risk, and interest rate risks(Pandey, 2008).
Market risk is caused by the reaction of the investor towards events in the economic environment. For example, investors may expect a reduction in corporate profit especially in this period of world financial crisis. This may cause a fall in the prices of shares. The events that affect the market risk include political, social, and economic. It is normally associated with the emotional instability of the investors or the ability of the investors to accept risk. The market risk is usually associated with massive buying of stock pushing price below or above the fundamental value of the stock. For example, if there is a trade of war or assassination of a prime minister or a president may be one of the causes that will push the prices far below the fundamental value (Brealey, Myres and Marcus, 2001).
Interest rate risk which is part of systematic risk is the risk that arises due to uncertainty of the future market values and the future income stability. This may be caused by constant fluctuations of general interest rates in the market. The interest rates are usually determined by the government securities such as treasury bonds and bills which offer alternatives, instruments for investment for the private sector. If the government decides to issue the securities at a higher price then we expect the private sector to invest in the treasury bills in the process to push the general prices to go up(Brealey, Myres, and Marcus, 2001).
Purchasing power risk is the risk of uncertainty of the citizens to remain at the current purchasing power for the amount received. This can be defined in simple terms as the dollar now is not equivalent to the dollar tomorrow because of the interest rates prevailing in the market. In fact, the purchasing power risk is a result of the inflation rates that are taking place in an economy that is affecting consumption. The rising in prices of goods and services is another form, of inflation that affects the purchasing power(Westerfield, Jaffe and Jordan,2007).
The market risk interest rate risk and purchasing power are the principal sources of systematic risks in the stock exchange. This form of risk cannot be controlled through diversification but can be controlled through government policies. Therefore as the board of directors, you can do nothing to manage this risk except by teaming up with other stakeholders in trying to persuade the government to mitigate these risks because it moves with the market (Westerfield, Jaffe and Jordan,2007).
Unsystematic risk is the risk that arises from the uniqueness of individual securities. This form of risk can be diversified to reduce it. If a corporation invests in a wide variety of securities thus diversifying the portfolio, the uncertainty under unsystematic risk will be reduced. In diversification, it means that a corporation can carry out mergers to reduce this risk. factors that influence this form of risk include, the capability of the management, consumer preference, labor strikes, variability of the returns of the company, the financing environment of the firm, the operating environment of the firm, the declaring of strikes by the Unions, entry of competitors into the market, loss of contracts by a company, the company succeeds in inventing a new product, the company losses the ability to secure raw materials and many others. There are many forms of these risks and they include business risks and financial risks (Pandey, 2008).
Financial risk is the risk associated with the financing of the company’s assets. A company’s capital structure portrays this form of risk if the company has a high debt to capital ratio then we expect that company to have a high risk. The presence of debt capital in the capital structure causes the common stockholders to have a high profit. This risk can be avoided through prudent management, of the capital structure by the board of directors and the management. A company without debt capital has no financial risk. The inclusion of debt capital into the capital of the company is ensuring the variability of returns to common stockholders and the increase of risks (Brealey, Myres, and Marcus, 2001).
Another form of unsystematic risk is a business risk which is due to the operating environment under which the firm is operating and the ability of this environment to influence the expected returns of the company. Business risks are usually categorized into two, internal and external business risks. Internal business risks are associated with the management of the firm since it is to something to do with the efficiency at which the management is to do some business. The degree of this risk is left to the management and cannot be diversified and can be left to the management. External business risks are a result of corporating conditions of the business but from the external environment. Each firm has its external risks and this includes the costs of borrowing money to do business, the downsizing or the number of staff members, demographic influences, political policies, advertising strategies, and many others. This form of two risks forms what we call unsystematic risks or diversifiable risks (Brealey R. Myres and Marcus, 2001).
Total risk is the risk of individual security influenced by the two combined risk that is systematic and unsystematic. The variability of the price of a stock is usually explained by this risk (Pandey, 2008).
Total risk of a security = systematic risk = unsystematic risk
Systematic risk is the covariance of the individual securities in the portfolio. An investor has to suffer the systematic risk, as it cannot be diversified away. The difference between variance and covariance is the diversifiable or unsystematic risk. Thus equation above can be written as (Pandey, 2008):
Total risk is not relevant for an investor who holds a diversified portfolio. The systematic risks cannot be diversified and therefore, she will accept compensation for bearing this risk. She will be more concerned about that portion of the risk of individual securities that she cannot diversify. The following graph below shows that unsystematic risk can be reduced as more and more securities are added to a portfolio. It has been found that holding about fifteen shares can eliminate unsystematic risk. Diversification’s aim is not to reduce the unsystematic risk. Thus the source of risk for an investor who holds well-diversified portfolios is that the market will swing due to economic activities affecting the investor’s portfolio. Typically the diversified portfolios move with that market (Pandey, 2008).
(Pandey, 2008, pp.94)
The board of directors’ concerns or comment about risks shows different forms of attitude towards risks. Three forms attitudes have been presented by the three directors’ comments. These include (Pandey, 2008);
Risk-averse investors attach lower utility to increasing wealth. For them, the value of the potential increase in wealth is less than the possible loss from the decrease in wealth. In other words for a given return, they prefer less risk to more risk.
Risk-neutral investors attach the same utility to increasing or decreasing wealth. They are indifferent or more wealthy for a given return.
Risk–seeking investors attach more utility to the potential of additional wealth to the loss from the possible loss from the decrease in wealth. For earning a given return they are prepared to assume higher risk. The graph below shows risk preferences of the three types of investors;
(Pandey, 2008, pp.77)
The first comment states that if we hold a portfolio of stocks we need only to consider the systematic risks of the securities shows of an investor who is risk-taking because unsystematic risks cannot be diversified therefore the investor is risk loving (McLaney, 2003).
The statement that has a conscious investor we must always consider total risk shows that the director who issued the statement is risk-neutral. A risk-neutral investor is an investor who views risk both systematic and unsystematic risk to be equal(Westerfield R., Jaffe, and Jordan,2007).
The last comment shows that the board member is completely risk-averse which is why he is suggesting that the investment should be made which is not below the risk-free rate assets (Westerfield R., Jaffe, and Jordan,2007).
Cash Flow Discounting
Cash flows are discounted because the dollar today is not equivalent to the dollar tomorrow. In fact, if one has 100 dollars will have a different purchasing power one year from today. This requires the discounting of cash flows. The reason why the cash flow today is not equivalent to cash flows tomorrow is because of the inflation rates that affect consumption (University of Leicester, 2002).
Suppose an investor has 100 million to invest where it will be 110 million in two years to come while there is another investment which will give immediately and the total amount will be 108 million, will it be prudent to invest in the 110 million. This is not prudent because the time at which this money or this investment is being recouped is different and it will take a long time for the shareholder to maximize their wealth. Therefore discounting of the future cash flows is for the following reasons (Brealey R. Myres, S. and Marcus, J., 2001).
- for the interest foregone – if a person invests 100 million today this 100 million will be tied up in the investment and cannot be invested somewhere else therefore discounting the future cash flow is to cater for this interest that will be foregone once the investment is made(McLaney, 2003).
- Inflation rate – as time goes by inflation rates bites and the value of money or the purchasing power of the dollar is reduced because the dollar today is not equivalent to the dollar tomorrow (McLaney, 2003).
- Risk – the investment made today may not be recouped tomorrow because of various risks which are both systematic and unsystematic risks. In discounting cash flows this uncertainty is taken into consideration and forms part of the discounting rate (McLaney, 2003).
To determine the viability of eh project various techniques are used which are both traditional and non-traditional. Traditional techniques do not consider time, while non-traditional consider the time value of money. One of the techniques used to determine the viability of the project is the net present value and is commonly used in determining which project is viable by most academic institutions and small businesses (University of Leicester, 2002).
The net present value method considers discounted cash flows and recognizes the time value of money. It helps to compare and adapt cash flows from different periods when cash flows are forecasted based on realistic assumptions. The decision rule under the net present value is to accept a project which a positive net present value. When projects are mutually exclusive and both have high positive net value you choose the one with the highest net value. Net present value has many advantages and disadvantages and some of the advantages include consideration of time value for money, measure the true profitability of the project, helps in ranking the projects, and many others(Pandey, 2008).
The project under consideration, in this case, has five years with an Investment at year 0. The cash flows are not uniform annually therefore it can be estimated by adding up the present value of each period. The following formula will be used.
Net present value = present value of cash flows – initial investment
The following table is used in calculating the net present value
|Present value factor of annuity @ 12%||1||0.893||0.797||0.712||0.636||0.567|
|Net present value||2,160|
Assumption: It is difficult to state whether the amount recorded as (100, 00) is 100,000 or 10,000 of investment. That is why I have given two alternatives for these assignments and both lead to the same decision.
|Present value factor of annuity @ 12%||1||0.893||0.797||0.712||0.636||0.567|
|Net present value||102,160|
The net present value considering the initial investment of 100,000 will be 2, 160, while the initial investment of 10,000 will give a net present value of 102,160. In both cases, the net present value is positive therefore the project is acceptable.
Decision: the net present value is positive therefore accept the project.
New capital budgeting proposals must be considered in light of both existing projects and other proposed projects, and projects selected must be those that best diversify, or reduce, the firm’s risk while generating an acceptable return. Successful diversification may make a risk of a group, or portfolio, of projects less than the sum of the risk of the individual projects. To diversify risk to create an efficient portfolio, which allows the firm to achieve the maximum return for a given level of risk or to minimize risk for a given level of return, the concept of correlation must be understood(University of Leicester, 2002).
There is a need to understand an investment proposal from May’s different angles to determine its viability and future economic performance. The capital budgeting technique discussed here and their merit cannot be detracted from since these are time-tested methods (University of Leicester; 2002).
Brealey R. Myres, S. and Marcus, J.(2001). Fundamentals of Corporate Finance, Irwin series in finance, Boston, MA: Irwin/ McGraw – Hill.
McLaney E., (2003). Business finance theory and practice; Prentice Hall ISBN 0-273-67356-4.
Pandey I M (2008). Financial management, vikas Publishing House PVT ltd, pp.77-78 and 90-95.
University of Leicester; (2002). Finance and growth strategies; MBA Business Administration.
Westerfield R., Jaffe, and Jordan (2007). Corporate finance core principles and applications , McGraw-Hill. ISBN-13: 978-0-07-353059-8/ISBN-10:0-07-353059-X.