Risk_Analysis

Running head: RISK ANALYSIS Risk Analysis University of Phoenix MBA 540: Maximizing Shareholder Wealth Thursday, August 06, 2009 Risk Analysis (started @6:15) “Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns). It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project. (University of Phoenix, 2002 )” In the Capital Budgeting simulation, Silicon Arts Incorporated (SAI) was in a strong financial position with plans to pursue growth options that would allow them to increase their market share and keep pace with technology. This paper will discuss valuation techniques associated with SAI’s investment strategies as well as analyze their associated risks. Valuation Techniques From the simulation, SAI had the option to pursue two paths to meet the desired growth goals. The first path was an internal investment option centered around expanding their existing Digital Imaging market. The second path was an external investment option that would allow them to enter the Wireless Communication market. After some careful analysis, the growth path for SAI would eventually be decided based on the results of one of the following valuation techniques: Net Present Value (NPV), Internal Revenue Review (IRR), or Profitability Index (PI). Net Present Value is the first valuation technique considered in the valuation of the two options being explored by SAI. “The Net Present Value (NPV) of an investment (project) is the difference between the sum of the discounted cash flows which are expected from the investment, and the amount which is initially invested. (12Manage, 2009)” In making investment decisions, a positive value for NPV represents a good investment with the understanding of the following limitations: • the calculation of NPV does not account flexibility after the project is selected • the calculation of NPV does not account for intangible benefits Mathematically, NPV looks as follows: NPV = [pic] and determines how much cash will result from an investment. Therefore, if the calculated value which is also referred to as the present value of money is greater than the [pic], the project would be a good investment. IRR was the second valuation technique considered in the valuation of the two options being explored by SAI. “The Internal Rate of Return (IRR) is the discount rate that delivers a net present value of zero for a series of future cash flows. It is an Discounted Cash Flow (DCF) approach to valuation and investing. (12Manage, 2009)” This method is similar to NPV in that it aids managers in making decisions on which projects to invest. In general the percentages involved with IRR are considered easier to understand than NPV. However, IRR has the following limitations: • in the case where a project is forecasted to have a negative cash outflow after having a positive cash inflow IRR becomes unreliable • not very dependable in the case where projects are mutually exclusive Mathematically, IRR looks as follows: [pic] where C(n) represents the cash flow for each period. Basically, the IRR can be found by setting the NPV to zero and solving for the “r” term in the equation. PI was the third valuation technique considered in the valuation of the two options being explored by SAI. “Profitability index is a finance term that tells us the potential payoff of an investment compared to the initial cost of investing. Profitability Index, often abbreviated as P.I., is a great indicator of how good of an investment you are making. It’s especially useful if you can only invest a limited amount. You can calculate the Profitability Index for multiple investment possibilities, and the one that has the highest P.I. value is the one where you should focus your resources. (Turner, 2009)” Mathematically, PI look as follows: [pic] where PV represents present value Risk and Risk Mitigation “As a the Financial Analyst of SAI evaluating two mutually exclusive capital investment proposals, you used different measures like NPV, IRR, and PI for evaluating a proposal. The reliability of these measures depends on your assumptions and cash flow projections. (University of Phoenix, 2002)” Variations in your assumptions can have important impact on the outcome of the measures used to evaluate the two growth options. This variation can generate an unexpected or unfavorable investment result. The idea of an unexpected or unfavorable investment result is the risk inherent in the Capital Budgeting simulation. However, in an effort to mitigate this risk, the best option for SAI was chosen by reviewing the outcome of all three valuation techniques. In the simulation, the financial manager had to make assumptions for sales, price and marketing cost for each option, to determine the feasibility of the capital expenditures, to account for hidden cash flows, and leveling cash flow streams. The use of just one valuation technique would have provide adequate results with the understanding of its limitations but the combination of all three would aid in providing a greater degree of confidence. Investment Decision Based on the NPV in the table above both growth options are appear to be good investments. The NPV for both projects is greater positive which according to the rules for calculating NPV represents a good investment. The IRR is positive and greater than the expected rate of return. However, the PI for both projects is not greater than one. PI’s greater than 1 represent a good investment. For the wireless communication option, the PI value was less than one which makes the investment less attractive. |Valuation Technique |Digital Imaging |Wireless Communication | |Net Present Value |9955 |5000 | |Internal Rate of Return |22.70 |22.75 | |Profitability Index |1.5 |.99 | Therefore, the investment decision that will potentially provide the growth opportunities desired by SAI is the expansion of the Digital Imaging market share. It is important to remember that the results of the calculation were based on assumptions made during the simulations. Slight variations in the assumptions made could have resulted in the Wireless Communication project being selected. Conclusion “Capital budgeting is very obviously a vital activity in business. Vast sums of money can be easily wasted if the investment turns out to be wrong or uneconomic. The subject matter is difficult to grasp by nature of the topic covered and also because of the mathematical content involved. However, it seeks to build on the concept of the future value of money which may be spent now. It does this by examining the techniques of net present value, internal rate of return and annuities. (Macdonald, Cheng, Carter, 1997)” With that said, companies have to be extremely conscience of investment decisions and their associated risks based on the limitations inherent in the corporate valuation methods. If not, they may find themselves dealing with the unexpected or undesirable results. Reference Gray, C. F., & Larson, E. W. (2006). Project management: the managerial process (3rd ed.). New York, New York: McGraw-Hill/Irwin. University of Phoenix. (2002). Capital Budgeting. Retrieved August 2, 2009, from University of Phoenix, Simulation, MBA 540- Maximizing Shareholder Wealth. 12Manage, (2009, August 05). Net Present Value (NPV). Retrieved August 5, 2009, from 12Manage: The Executive Fast Track Web site: http://www.12manage.com/methods_npv.html Macdonald, N.J, D.C.B. Cheng, & S. Carter (1997). Basic Finance for Marketers. Rome, Italy: FAO Regional Office for Africa.