FINANCE AND ACCOUTING
Question One: Risk Management
Part A: Risk sensitivity
Risk management entails identification, assessing, controlling possibilities of losses of firm’s capital and earnings. Threats could stem from a broad range of sources such as management errors, natural occurrences, financial uncertainty, accidents and legal liabilities. For effective management of risks, managers and owners of non-financial firm must demonstrate knowledge in identifying potential threats before electing one the range of strategies to utilize and, to manage it. The efficiency of risk handling strategies, example, risk acceptance, avoidance, transferring, and mitigation depend on the degree of the managers’ endowment with core competencies in risk sensitivity. Risk sensitivity is an important risk management in capital budgeting decisions. Capital budgeting decisions requires the use of quantitative a techniques that look at aspects such as discounted paybacks, an payback, profitability index, internal rate of return, and net present value. The latter NPV is considered the most important tool and its also part of the discounted cashflow. In computing NPV a manager would have to follow a number of key steps such as determination of both risks based incremental cashflows right from the start to the completion of a project, computation of the rates to apply during the discounting process, and the application of NPV model in order to calculate its value. The basis of this calculation is to compare the present values of a project incremental benefits with current values of other incremental costs. The procedure applies many variables during this process such as tax rates, relative uncertainty, fixed costs, depreciation expenses, cash flows and incremental variables. In practice, the risk adjusted an discounted rates can be used to tabulate the risk adjusted or even the calculate certainty equivalent cash flows. All of the factors represented in NPV calculation are essentially an estimate but each carry a different degree of precision. However, when the degree of uncertainty is exceedingly high the range of estimates tend to become comparatively broad which imply that the quantification of NPV would be more uncertain. Some managers can opt to apply static formulas to see how these variables change, and other may chose to use dynamic formulas based on the figures at hand. Whatever the case, the findings help to make investment decisions with long-term implications on risk management. With proper calculations, the figures could inform decisions that can help to avert and mitigate risks. A dynamic approach for instance, can guide manipulation of independent variables that can consequently help to perform some acceptable sensitivity assessment. Using a dynamic approach can also help managers and owner to analyse the potential of a project for one to breakeven. In this sense, quantification helps in determining, managing and controlling risks.
Part B: Risk Financial Return and NPV
Risk in respect of the financial return or NPV should be controlled for by correct choice of a discount rate. Since the primary goal of any business is to generate profits, it is important to manage risks in contemplation of the return on investments. In respect to this, owners manage risks using a number of strategies. To start with, the managers can start with defining uncertainty. No doubt the future is fraught with much uncertainty, but it is possible to anticipate it. For example, it is possible to fairly predict daylight breaks something that arise of the myriads of observations collected over the time. At the same time, it is difficult to predict with accuracy on the future predictions. In reality, a number of factors governs the ability to develop accurate forecasts. The ability to make forecasts largely depends on the makers’ experience. However, in some situations, it is possible to make an objective assessment of statistical data for a clearer picture to predict the future value.
Another strategy that can be used it performance of risk analysis. A major has a lot tools at disposal for risk analysis. Some of these include probabilistic simulation such as the Monte-Carlo simulation technique. In this strategy for instance, an uncertainty calculation is determined using forecasting main variables to reveal the impact of risk on projected results. The strategy entails subjecting a mathematical model to multiple simulation runs on a computer program. However, the simulation has to be controlled to ensure the random selection of values in a probabilistic distributions remain the range of values of known correlational and existential relations. The results are then collated to come up with a probabilistic distribution that can help to determine to project the outcomes of various values. The initial stage in forecasting risk is the adoption of a robust model that come up with proper predictions when fed with the right data. Other steps that follow is setting the range of limits, and allocation of probabilities. Prior knowledge on the expected risks can inform decisions that can help to reduce and where possible avert unnecessary risks. According to risk analysis is important for project appraisal which is only possible risk premium. The size of risk premium can be subjective though and in some times complex particularly in underdeveloped states. In a deterministic analysis, decision criteria allows for comparability and validity analysis. The value arising from this probabilistic distribution of NPV also derived from the same discount rate can be deemed the summary indicator of the net worth of business.
Part C: Certainty Equivalents Calculations
A manager owner can also handle risk using certainty equivalents. A certainty equivalent for a certain alternative is an equally preferred alternative based on its projects. It is also known as a selling price of that other alternative. The concept of certainty equivalent is important because it appreciates the factor because the value of risk alternatives can differ enormously since some alternatives could bear serious losses. However, various attitudes can determine calculations of the value of certainty equivalents. Most managers prefer expressing it in terms of profits, which is in most cases make it less than the profits projected in a profits of other alternatives. In such circumstances, a manager is considered to be risk averse to those types of alternative. In contexts where certainly equivalents is deemed equal to profits generated from alternative, the managers can be considered to be risk neutral. Still some managers can opt to manager risks by being risk seeking. In the latter, the certainty equivalent is considered higher than profits generated from alternatives. However, few if any managers will take a risk seeking approach. The reason for this is that in respect to various decisions made for a firm, in the long run, one could go broke due to difficulties recovering the enough money from the alternatives. Since would be much willing to pay for all of them (Heaton 2019). That no doubt is not a typical behaviour in business management.
In various decisions, the manager has to calculate certainty equivalents and their preferred alternatives. Often, these calculated using modified procedures utilize utility function to reveal the expected values. The underlying notion behind this concept is to calculate certainty equivalents by first converting all possible outcomes of a decision in question to utilities followed by calculation of each expected alternatives using a similar utility function. Essentially, utility function helps the owner to translate each outcome into numeric. In practice, it has been appropriate to utilize exponential utility (u(x) = 1 ¡e ¡ x=R; R > 0) particularly in decisions that involve profits determination (Zhang 2013). The procedure designates the expected value as the primary determinant for various decisions. The practice fits the context of businesses since decisions have to be future oriented to handle contingencies. To calculate certainty equivalent, the coefficient is presumed to be bigger than zero but smaller than one. The method is, however, suggestive, and correct to most people, but it has its shortcomings since in theory and practice, because of difficulties in coming up with a reliable estimation method.
Question 2: Choosing a Discount Rate
Every firm requires a discount rate before deriving a Net Profit Value (NPV) of a project. Traditional practice considers a discount rate as a Weighted Average of the Cost of Capital of the firm (WACC). Of course, like mentioned previously, it down means that a decision arising from such a calculation will be absolutely true. For instance, two firms could have WACC of 10 per cent and B 60 per cent. In terms of NPV rule, the return on investment opportunity is 50 per cent which means that firm should logically accept it and firm B should or may have to reject it. Interestingly, it is not a rational decision for the firm B to reject the opportunity since it would be extremely difficult to come across a projection with a return of something close to 60 per cent. In a practical setting, capital budgeting decisions should precede those arising from financial decisions. This means that the cost of capital is irrelevant in making an investment decision. It also means that, it is wrong to use WACC or anything that is founded on it as a discount to calculate net profit value. That notwithstanding, it is considered by most people to be the most popular method of determining discount. To this end then, a more noble question is then what is the most important method of determining discount.
A more proper way for determining a discount rate should be rate-based arising from the risk of a project. This type is referred to many a risk-adjusted discount rate. The most common approach in calculating this applies a Capital Asset Pricing Model (CAPM) which is expressed as E(Ri) = Rf + βI [E(Rm) – Rf ]. In this model E(Ri) is considered the expected return and Rf is the interest rate free from risk such as that arising from government bonds, βi is the determined sensitivity of assets, E(Rm) the expected returns in the market, and E(Rm) – Rf the market risk premium.
CAPM Model of determining discount rate was first developed by William Sharpe, which was a modification of the previous work diversification and modern portfolio theory. Today, CAPM is considered the only model that shows the relationship between a risks and return. It is very easy to use since it establishes linear correlation between the two variables. The central argument of this model is the underlying defining assumptions. Some of the assumptions of the model include but not limited to: investors have unlimited freedom in selling shares, the market is governed by perfect competition, sale and purchase transactions can be divided into infinite units and investors can lend and loan whichever amount at risk free rates. Some of these assumptions are in a way unrealistic, but provide a basis for establishing an efficient frontier line for control applicable to all people.
Despite the popularity of this model is determining discount rate it faces serious limitations. To start with it only accounts for market and systematic risks. Consequently, it ignores firms total risks. In practice, when making an investment decisions, both systematic and non-systematic risks comes into play. For this reason, the CAPM fall shorts of accuracy for lack of comprehensiveness. That notwithstanding, the model introduced the concept of systematic risk, an element previously left out in by the other models such as dividend discount model DDM. Systematic risks are an important in determining discount rates because such risks are often unforeseen which means that it is difficult to mitigate them in finality. In addition to that variances between financing and business mix imply that, some return calculations such as WACC would not lead to the correct figures. Another disadvantage is that some of its assumptions do not accord a realistic picture. For instance, in reality individuals cannot lend and borrow at a risk free rate a real market. As a fact, the lower needed return line could be more steep than the model would calculate. All these shortcomings would no doubt affect calculation of discount rates.
Question 3: Views in Readings One and Two
The two readings provide important insights. To start with, the discount rate is an important element in project valuation of cash flows. The insight is consistent with the answers in the sections one and two. Argumentatively, Lubatkin et al. 2003 perceives the traditional methods as a wrong approach in risk assessment is not an out-dated one. Part of the reason for this is that the traditional approach only emphasises a capital asset pricing model, which inadvertently places a firm at risk. A specific element in this case is beta, which is perceived as unreliable since it captures risks only from the perspective of shareholders and managers. This like mentioned earlier in earlier cedes the arguments in previous answers that revealed the inconclusive nature of CAPM in developing a discount rate in the previous as discussed in questions one and two. It is from this shortcoming Lubatkin et al. suggest need for a better model for more accurate predictions that provides a more total risks. To this author, projections derived from a more consistent with the modern moderns and evolved theory. Again this view is consistent with the views expressed previously. In the contemporary markets, investors need more than the ordinary incentives (a risk premium) as an insurance against risks in case the earnings of a entity fall short of market expectations. This is important because the modern breed investors will only make heavy investments only if the expected returns are heavy enough to justify the risks involved. The concept of a risk free market suggested by a CAPSM model does not reflect the realities of a real life occurrences. Likewise, beta in in the traditional formulae only captures part of the insurance needed by the investors to invest confidently. What this means is that, this approach Is not likely to help assist fully in risk management.
Reference List
Heaton, J.B., 2019. Simultaneous Risk Aversion and Risk-Seeking Behavior in an Expected Utility Framework with Optimism. Available at SSRN 3362094.
Zhang, Z., 2013. Certainty equivalent, risk premium and asset pricing. In Finance–Fundamental Problems and Solutions (pp. 51-69). Springer, Berlin, Heidelberg.
Lubatkin, M.H., Schulze, W.S., McNulty, J.J. and Yeh, T.D., 2003. But will it raise my share price? New thoughts about an old question. Long Range Planning, 36(1), pp.81-91.