Finance and Growth Strategies
Risks
Risk is defined as the existence of uncertainty about future outcomes to an economist. Basically, risk is a key factor in economic life because people and firms make irrevocable investments in research and product development, plant and equipment, inventory, and human capital, without knowing whether the future cash flows from these investments will be sufficient to compensate both debt and equity holders. If such real investments do not generate their required returns, then the financial claims on these returns will decline in value.
A key conceptual advance in risk analysis occurred when analysts began to describe the risk of an investment as being equivalent to the distribution of potential outcomes, where the distribution consists of all possible outcomes weighted by their relative probability of occurrence.
Risk is not only a source of randomness on the return of investment but also a measure of this variability because the probabilities of various outcomes are known (Stickney & Weil 1997 G-80 and Culp 2001 p. 80). Actually, elimination of risks to avoid untoward results should address initially two questions; namely, is it complete elimination and what is the cost of any reduction? For example, there is a chance that an asteroid could hit the earth according to some experts but would the probability of the event (i.e. 1 in 1 billion) can be substantial enough to create the need to create homes in caves and underground which have monetary and non-monetary costs (Culp 2001 p. 7). Lastly, preferring zero risk is equated to a risk-averse person. For example, even though the probability of wining a $1,400 raffles ticket at a cost $700 is 50%, a risk-averse person will not bet his $700 due to the adversity on having nothing. This despite the expected value of buying the raffle ticket and betting is $700 (i.e. ½ ($0) + ½ ($1,400) = $700) which means there is an equal probability of doubling his money (Culp 2001 p. 8). Actually, in measuring risk, variance, standard deviation, diversification, unique risk and market risk is considered. Variance is a measure of volatility and is the average value of squared deviations from mean; standard deviation is also a measure of volatility and is the square root of the average value of squared deviations from the mean; diversification is the strategy designed to reduce risk by spreading the portfolio across many investments.
Total Risks
Consistent with a rational market, individuals and other entities expect and are promised with higher (lower) returns if they engaged in investments with higher (lower) risks. Shareholders are concern with total risk because it is a measure of the risk of an exposure of business portfolio that is comprised by the sum of market and firm-specific risks. Due to this, investors can reduce their total risk through diversification without altering their expected return (Das 1993 p. 293). However, this incentive is less attractive to contemporary investors because firm-specific risks are automatically considered when they hold a certain number of securities. As a result, firm specific risk becomes irrelevant to investment motivation because investors do not have to bear the firm-specific risk and therefore do not have to be compensated (Das 1993 p. 295).
To measure the total risk of a portfolio, correlation and covariance should used (Mcmenamin 1999). The first step to do is to get the return of the portfolio. This is merely the sum of expected returns of single-asset multiplied with their proportional share in the investment amount. Say I have $1000 and opted it to invest in stocks and bonds in two different companies. If I will invest 50:50 on each financial instrument, their earlier computed single-asset expected values should be reduced to 50% and be totaled. In the same manner, their earlier computed standard deviation should be reduced to 50% or their share of the $1000 investment. However, the problem of the preceding statement is that the standard deviation or the risk could lead to inaccurate decision information. Due to complexity of two-factor and much of the multi-factor portfolio than single-asset, the procedure requires further information about stocks and securities.
Distinction between Systematic and Unsystematic Risks
It is important for an investor or a firm to assess associated risks for every business engagement. There are risks attached to inability to repay short-loan liabilities due to abrupt demand payment. On the other hand, a more long-term security can extend the debtor days of the investor but still risks on paying large interest and principal can lead to default. Therefore, assessment is required to know the level of risks associated to a given level of return on certain assets (Stickney & Weil 1997). In this regard, unsystematic risks are those risks associated with price changes due to unique characteristics of certain securities that can be eliminated or minimized through diversification (Investopedia 2009). On the other hand, systematic risks are risks found in the entire class of assets which implies that they are sensitive to economic changes and market shocks. In effect, the latter kind of risk is less diversifiable and assets in a portfolio are more prone to inherent risks. Perhaps, when assets outperform the market, systematic risks can show its superiority in terms of higher returns with the security.
It is suggested that when an investor participates in the marketplace, he is compensated by systematic risks and not unsystematic risks (Risk Glossary 2009). This is consistent to the dogma that returns and risks have positive relationship, that is, when returns increase or decrease the same thing happens to risks. The adverse effects of unsystematic risks is ultimately dissolve in the marketplace as the investor net exposure is hedged through diversification by merely holding a number or combination of assets. Therefore, the only risks that should be in question is the systematic risks in which the investor cannot fully depict. In effect, the investor’s returns only confront systematic risks in the marketplace.
Markowitz efficiency frontier can clarify this statement (cited in Hitt, M, Hoskisson, R & Ireland D 2003). This frontier not only shows the optimal portfolio but also indicates how a risk-taking investor can maximize returns. The frontier assumes that there is no effect from trading costs like commissions rather the factors that can affect decision is on return and risk factors. All points in the efficiency frontier are diversifiable because it is a combination of risk-return trade-offs. All the points that lie in the efficiency frontier and therefore its constituent assets diminished specific risks associated with individual assets. This is because of diversification. However, it is to be noted that systematic risk or the risk in the market or external factors are not stabilized and always moving.
Derivation of Unsystematic Risk
Business risk is related to operating features of a firm while financial risk is related to the strategies behind the capital structure of a firm (Mcmenamin 1999). The former is a type of risk that is outside the control of firms and hardly affected by certain tactics and strategies because business risk is very dynamic and uncertain. On the other hand, the latter involves factors within the scope of managerial control because it arises from borrowed funds the company is bound to pay unlike equity funds. However, they are both under the definition of systematic risk or inherent risks of companies that cannot be reduced by diversification strategies. Business risks includes example such as the sensitivity of competitive structure of an industry to changes in macroeconomic variables such as inflation and interest rates. On the other hand, the more debt a firm has a greater level of financial risk or inability to meet such obligation.
Valuation can come directly to the firm. This is referred to as business risk (Bolten 2000). For example, its integration effort has indicators of failing (partly indicated in high employee turn-over from a proposed merger), thus, requires greater returns for the heightened risks of integration failure. On the other hand, electric utilities initially have relatively lower business risk compared to aggressive and expanding firms. This is so the expected earnings will not largely depart from the original due to business risks.
Lastly, financial risk basically provides valuation of investors that the firm can control (Bolten 2000). By merely looking in its financial statements, an investor can decipher financial risk involve in his stock investment. In the similar manner, he can assume his position of its value. For example, in capital structuring, common stock price will be undervalued when the firm is over- or under-leveraged. Although leveraging is good for the health of the firm, this suggest relatively complex forecast of future earnings of investors. This may also mean that debt servicing requirements might not be met, and as a result, it can affect the dividend pay-out or long-term goals of investors in their stakes on the firm. In additional, the level and duration of loan repayments is taken into consideration to calculate financial risk. Another, leverage buy-outs can dramatically pull the price of common stock.
Derivation of Systematic Risk
For example, every stock in London Stock Exchange is uncorrelated with every stock; the beta coefficient is zero (Investopedia 2009). In this case, it will be possible to hold a portfolio in LSE that has risk-free. Investors would be acting like a casino owner having to only wait at the end of the day to receive fees from the players. The owner will accumulate earnings without any risks in playing rather only responsible for maintaining the venue. With zero betas, game theory will not hold and stock markets will never exist as correlated risk is the source of all risk in the diversified portfolio. On individual assets, beta represents volatility and liquidity of the market place while on portfolio perspective it refers to investor’s level of risk adversity. Beta is estimated through times series analysis and linear regression models (Risk Glossary 2009) like estimating ninety trading days of simple returns used as estimators for covariance and variance. Negative betas can be derived by holding securities that move against the market, shorting stocks and putting on options.
However, betas are limited because they are only based on historical market data (Risk Grades 2009). As such, future implications to investments cannot be inserted in the decision-making criteria. Variables are identified based on their past performance and any future or expected changes are not taken into consideration. In effect, investors that accept and address this limitation often lead to speculation for a possible war, major earthquake, political scandal and other stock market related events due to the inability of the beta to represent the overall perception of the market about the future trends. In effect, it can be said that the limitation of the beta caused the stock market bubbles and other economic crisis that adversely affected the lives of the people; both rich and poor as over-speculation in the market lead to distorting the real performance of the market rather mere expectations of market participants without any proven level of superior output.
Director’s Comments
In the above discussions, the first comment that portfolio of stocks need to only consider systematic risk is valid. This is because the total risk of their holdings is already diversified by investing in different firms; therefore, unsystematic risk becomes irrelevant. The second statement only becomes crucial if the company is holding only minimal number of portfolio. However, total risk becomes important when the company decided to hedge their risks by holding government bonds which is said to be risk-free asset. In this regard, focusing only on systematic risk is limited in gaining the minimum level of risk. The third statement is true because when the expected return is smaller than the whole market the security in question is underperforming while when it is smaller than the risk-free asset the trade-off between risk and return is not optimized.
Actually, the concepts of cash flows, risks, and shareholder value, are extremely important in financial management. They form its fundamental building blocks, have a profound effect on financial decision-making, on the value of a business, and consequently on the wealth of its owners. Profits do not represent cash flows (Mcmenamin 1999). Although profits may be used as the traditional accounting measure of a firm’s financial performance and a firm may report healthy profits in its annual accounts, it does not necessarily mean that cash is actually available to pay bills and fund investment. For example, depreciation and other provisions are included in a profit and loss account but they are not cash flow items (Mcmenamin 1999).
Basically, time value of money or TVM is an investment principle in which investors prefers to receive the money as early as possible and that the value attached to present money holdings is greater than future or expected money holdings even they have the same nominal values (Mcmenamin 1999; Investopedia 2009). This is because market effects such as inflation, change in interest rates and regulations can increase or decrease the future value of assets, thus, making them more exposed to risks (Mcmenamin 1999). Deferral in consumption has also some forms of sacrifices which happens when an investor dedicatees present income and wealth to investments. In effect, the investor would demand interest to compensate such investment due to these reasons. For example, a loan requires interest payments, collateral and other forms of guarantees which indicate that TVM principle holds in the transaction. Further, equity investments in the form of stocks also provide dividends in both money and other assets as well as capital gains in the price of the stock. These are mere resolution of investors to compensate their sacrifices through the guide of TVM principle.
TVM is the foundation of discounting future cash flows although applied in most big business that plans to undergo huge financing for a project or several projects. The table below shows an investment project with cash flows that can contribute to firm’s value up to three years. As observed, forecasted sales needed to be converted in to their present values to be able to adhere to TVM principle. There is a standard table of future/ present values in which a particular discounts rate and specific year can be cross referenced to determine the discount rate for the particular year (e.g. .901).
As observed, as the value of future sales increase and/ or their timing go further from the present, the discount rate tends to be lower which means future inflows are deducted with relatively more discounts. Thus, discounting is a practical application on how investors assess associated risks for a particular return. That is, as returns tend to go further into the future, their value depreciates because moving further to the future suggests more ambiguity than the current time. And so, the higher the returns of these futuristic returns, the higher will be the deductions of the discount. This situation is consistent to the positive relationship of risk and return.
Project 1: DIY Renovations
Year
Sales
Initial Outlay
Discount rate (at 11%)
PV
-
-
75,000.00
1.000
75,000.00
1.00
10,000.00
-
.901
9,010.00
2.00
30,000.00
-
.812
24,360.00
3.00
100,000.00
-
.731
73,100.00
NPV =
31,470.00
The terminal year cash flow is relevant in financial analysis particularly in investment and budgeting because of its ability to estimate annual cash flows that a firm can have at specific number of years in the future (Mcmenamin 1999). The method allows the inclusion of the value of future cash flows to mitigate valuing problems. Computation is less complex since the use of constant rate for a going concern firm is suggested. When computed in present value terms, it can readily be added to the present value of free cash flows to determine the value of the business. On the other hand, when the firm is planning for dissolution, the approach can easily show the bearing to defer or expedite dissolution stages as getting the returns for a certain number of years in the future is possible.
Thus, the approach is flexible and a tool for forecasting. However, this strength have back clash making it necessary to consider some important factors. The discount rate and growth rate undergo perpetuity which means that there value remain constant from year 1 to year N (the final year). In the contrary, market conditions as well as internal performance of the firm are always vague especially on hi-tech and internet-based industries. In effect, environmental scanning and internal audit should be used to be able to have a more accurate representation of future PESTEL, industry, competitor and corporate strategy implications to discount and growth rate.
Lotus Bloom Bar and Restaurant
End of the Year
Cash Flow (in ₤)
Discount rate at 12%
Present Values (in ₤)
0
100,000.00)
1.000
100,000.000)
1
10,000.00
0.893
8,930.000
2
20,000.00
0.797
15,940.000
3
40,000.00
0.712
28,480.000
4
50,000.00
0.636
31,800.000
5
30,000.00
0.567
17,010.000
TOTAL
50,000.00
Net Present Value =
2,160.000
Since the NPV has positive value (₤ 2,160.00), the expansion of product line of the company tends to increase investors wealth, thus, should be a worth while strategy. However, as the NPV value is a mere 2%, the figure suggests minimal return for investors despite five years waiting to recoup and profit from their investments. Aside from minimal compensation to adhere the time value of money, the investment also failed to sufficiently compensate investors from the risk of the new product line being eaten by competition or ignored by customers. Due to this, it is concluded that other investment alternatives should be sought and make this option the last resort or as a means to diversify risk.
Bibliography
Bolten, S (2000) Stock Market Cycles: A Practical Explanation, Quorum Books, Westport, CT.
Culp, C (2001) The Risk Management Process: Business Strategy and Tactics, Wiley, New York.
Das, D (ed) (1993) International Finance: Contemporary Issues, Routledge, New York.
Hitt, M, Hoskisson, R & Ireland D (2003) Strategic Management: Competitiveness and Globalization, 5th Edition, South Western; Thomson Learning, Singapore.
Investopedia (2009) Systematic Risks viewed 18 April 2009, <www.investopedia.com>
Investopedia (2009) Unsystematic Risks viewed 18 April 2009, <www.investopedia.com>
Mcmenamin, J (1999) Financial Management: An Introduction, Routledge, London.
Risk Glossary (2009) Unsystematic Risks and Systematic Risks viewed 18 April 2009, <www.riskglosarry.com>
Risk Grades (2009) Times Series Analysis viewed 18 April 2009, <www.riskgrades.com>
Stickney, C & Weil, R (1997) Financial Accounting: An Introduction to Concepts, Methods and Uses, 8th Edition, Harcourt Brace and Company, Fl.
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