Risk management is an important activity to the private and public sectors. This is because risks occur as calamities in the public sector and in business sector they can cause imaginable losses. Just imagination losses caused by bad investment decision by a company management or the immense destruction caused by natural calamities such as floods, earthquakes, drought and many others. All these requires the people involved in decision making to identify risks and come up with ways of mitigating them.
Risk management decision
Risk may be defined as the probability that a prediction will turn out to be NOT correct. If there is a high probability that the outcome will considerably be in error, then the risk will be high. If the probability of substantial divergence is low, then the risk will be low. Obviously, if a project guarantees a good rate of return of, example, 15% per annum, one shall favors this over a project which promises to achieve this rate of return but carries the risk that it will fall far short of it. Risk may be reduced by a business through good policies of diversification (Hallows, 83).
The question may be asked, as to why; management should choose to invest in risky projects, if risk is seen as a problem? The justification for doing so is that, the most risky projects offer the greatest rewards. It is common tendencies for managers to make risk management decisions hastily that end up bringing negative consequences. Therefore risk management decisions made by managers should be of high quality in order to improve organizations performance. Some of risk management decisions made includes ;( Higgins, 108).
There are number of risks associated with businesses and we have a number of mitigating products. These risks will hamper the success of the project in the short and long run. The management makes decisions on how the risk should be identified. A varied range of activities help in both detection as well as conception of the organizational risk. This includes assessment of risks that are likely to occur in the organization. In order to understand the risk, first we must take the process of indentifying the severity of the risk. A decision on how to put the risk to an end is crucial. This begins at monitoring the risk and implementation process of the project (Hallows, 82-90).
Reduction of Risks
The activities that are geared towards risk reduction are mainly designed to mitigate losses from business risks. The forms of activities that address the present risks usually get the form of proper investment in right resources and regular evaluation of risk activities. Actions which are geared at reducing future susceptibility would mainly include the policies together with the enforcement of standards, techniques for guarding against losses, planning methods for good investment evaluation techniques as well as practices for proper resource management. The potential trends to attainment of objectives of the risk will be dealt with accordingly (Kousholt, 125)
In most cases there is always a possibility of eliminating the risks. There may be existence of important aspects of an investments which may remain at risk. Mechanisms of Insurance can be applied in the transfer of some of the risks which can not be mitigated by use of loss minimization techniques as well as the events that have the ability to lead to excessive financial losses.
The goal of these actions is to discover and reduce the susceptibility of an investment. Risks are determined through technical education as well as participatory workshops. Reduction of risks involves provision of finance investments that are less risky and the strengthening of building regulations as well as proper procedures, policies and standards. Bank projects mainly include mechanisms of transfer of risks which include catastrophic insurance and risk pooling (Stevens, 165).
Measuring project risk
The measurement of project risk is quite important in the overall evaluation of capital budgeting projects. Being able to measure the risk of capital budgeting projects lets one somehow differentiate between those projects having similar returns. One’s ability to compare projects will differing returns is also greatly enhanced, since one can get some feel for the type or risk return trades –offs offered by the projects. In order to measure project risk, a decision maker must be able to differentiate between the variability of project returns (Fischer and Jordan, 78-88).
The standard deviation of a distribution of project returns represents the square root of the average squared deviations of the individual observation from the expected value.
The coefficient of variation, V, is calculated simply by dividing the standard deviation, σ, for a project by the expected value, E, for the project. The following equation presents the equation for the coefficient of variation = σ/E (Fischer and Jordan, 78-88).
Time is an important consideration in evaluating the risk in a capital budgeting project. Key factors said to differentiate capital expenditure from operating expense is the amount of time over which the benefits from the expenditure is expected to be received. Capital expenditure have benefits received over a period greater than one year and quite often greater than five years. In order to evaluate these capital expenditures, consideration must be given to the fact that future industry and economic factors may greatly affect the project outcomes (Fischer and Jordan, 78-88).
Risk must be viewed not only with respect to the current time period, but as an increasing function of time. Although the cash flows associated with a given project are expected to resemble an annuity, and therefore have similar expected values. It is not unusual to find differing degrees of risk. Even where the expected values are not believed to be equal in each year, the probability distributions of cash flows will probably become more dispersed with the passage of time due to the difficulty of accurately forecasting future outcomes. As a rule the further into the future one forecasts cash flows the more variable and therefore the more risky forecast values are (Ireland, 48).
One of the difficulties of estimating future returns in a risky situation is the complexity of the influences which may work on them. Returns are not a simple uncomplicated quantity. They are the result of various factors, i.e. the revenues less all the relevant costs, and each of this may be subject to its own special risk unrelated to that affecting the others. In order to simplify the situation somewhat, use may be made of what is known as sensitivity analysis to isolate the more important factors from the less important. All that is meant by this is that we test the various factors to see how vulnerable the overall outcome of the project is to valuations in each of its own (Rooy, 189).
One of the simplest ways of considering the risk of a project is to use sensitivity analysis. Sensitivity analysis involves using a number of possible outcomes in evaluating a project. It is probably most useful in truly uncertain decision situations. The basic procedure is to evaluate a project using a number of possible association cash flows to get a “feel” for the variability of the outcomes. One of the most common sensitivity approaches is to estimate the worst, the expected and the best outcomes associated with a project (Latane, 45)
Directs costs and benefits
One method of dealing with risk is to ignore it all together which is very costly to the organization. It may seem odd to regard this as a “method” but it can be so regarded if the risk element has been specifically considered and it has been decided that it is random in its incidence and is as likely to cause better than expected results as it is to cause a worse than expected. Most of this has a direct cost bearing to the company.
In most cases we are likely to find that the nature of risk is such that we may find a project doing substantially worse than expected but rarely substantially better than expected. There are good reasons to anticipate this. One is that when people are putting up a case for capital on a project in which they are interested, they may tend to be optimistic in their expectations. Another is that estimates may be based on the assumption that an investment will be worked at or near to its full capacity. In that case there is little potential for improving on expected performance but plenty of scope for falling below it (McLaney, 178).
A method commonly used for dealing with this situation is the use of what is known as a “risk premium” discount factor. The use of risk premium rate will cause the company to reject some projects which it should have accepted, i.e. they appeared profitable both in prospect and in retrospect. Provided that there is no shortage of available projects this may not be particularly important (McLaney, 179)
Indirect costs and benefits
Risk indirect costs are critical situations that management must consider while settling on a given undertaking. The risk that an individual or organization takes must be minimized while giving more room for benefits (Van Horne, 189).
The first risk associated with the project will be the risk of staff turnover. The staff member may decide to leave because of fear of change. This is a human risk and it can be mitigated by involving the staff members in decision making and explaining to them the importance of the project to avoid negative attitudes towards this project. If proper change management process is not followed, the project may face resistance and eventually collapse. If it doesn’t collapse majority of staff members will be forced to leave (Brealey, Myres and Marcus, 126).
The project being new and the issue of resistance not being addressed properly some members may opt not to turn up to their workplaces because of fear. There is the issue of strategizing the budget beyond limit. Implementing a new project will require planning, organizing and monitoring accounting processes in procurement. This requires huge financial outlay to make this possible. The probability for this risk is over 60%.
The management may forget the importance of change management which assist businesses to implement project which are difficult at the initial stages. Change must be properly managed in order for the organization to have a good result for the project. This will ensure the project doesn’t face resistance from staff but compliance with resisting machine (Fischer and Jordan, 78-88).
Other costs include effect of performance of a company and profitability. A firm’s exposure to risk depends on the host country’s political system, its economic conditions and the government’s policies and actions towards foreign direct investment that affect the firm’s investment cash flows. A country with large deficit relative to the gross domestic product, high growth of the money expansion, fully or partially controlled exchange rate, enormous public sector firms, huge low yielding government expenditures, controlled prices and interest rates and trade restrictions would have potentially high political risk. A country with poor economic performance, low degree of economic integration with the world system and controlled political regime poses high degree of political risk. The most frequent political risks arise on account of the host government’s regulations that constraints the efficient operations of the foreign firms. There is conflict of goals between the host government and the foreign firms that lead to regulatory constrains on the foreign firms’ activities. The host government may restrict repatriation of dividends, may impose additional taxes on the income of the foreign firm or may control price of its output after the firm has made investment in the host country (Dornbusch, Fischer and Begg, 82).
Currency swaps will solve the problem of transaction risk because a borrower based in a different country who agrees with the current countries debt holder to exchange the debt. Swaps are combination forward contracts. In an interest rate swap, for example, one party promises to pay the other a fixed interest rate on a specified amount in return for a variable rate on the same base. This agreement encompasses two contracts: one covering the fixed rate payment, the other variable rate payment swaps are frequently used for foreign currencies as well as interest rates. Interests’ rate and currency swaps can also be used in tandem (Luecke, 93).
The company needs to have change management strategies in order to optimize the position of the firm in implementing the new project. The period between the emerging events and the consequences that follow after the project has been implemented will affect the project drastically. Therefore the strategic response to changing conditions of E- book must be determined and the human factors that are involved. The organization must create a learning method which shapes organization politics reshaping institution culture, skills of the staff about the new e-book, bringing in new ways of knowledge management, plan on emotional intelligence assessment and create self managed teams. The company must start from the top in implementing there is project by ensuring the leadership accepts this project for it to be successive. (Phillips, 120)
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