Discuss About The Risk Tolerance In Financial Decision Making?
Several techniques are used in evaluating whether or not to proceed with financial projects or not especially when risks are involved. Some of such techniques are the Net Present Value (NPV) and the Profitability Index (PI). The two techniques mentioned above consider the profitability of a both a single or mutually exclusive projects. Using the NPV technique, a single project can be accepted if the expected NPV is positive and rejected if the NPV is negative. For mutually exclusive projects with positive NPVs, the one with the higher figure should be accepted ( Horngren , et al., 2011, p. 43).
When it comes to the Profitability Index, the law states that a proposed project with profitability ratio that is greater than one should be accepted because it would be profitable. The project should be rejected if the profitability ratio is less than one. For mutually exclusive projects, the one with the higher profitability ratio should be invested in. In the case where the profitability ratio and NPV are zero (0), a company should choose to either accept or reject the project because either way the entity’s status quo would remain the same (Drury, 2015, p. 99).
In the case of the Zircon Company, the net present value should be determined by different situations as listed in the case study, i.e., make a deal with the Argentinean firms, the Argentinean government, or the Alternative strategy after hedging the Peso revenue. The Zircon Company’s net present values under different situations are calculated as shown below;
ARS 5000,000 x 0.12 = $600,000
Note: Initial Cash Outflow is US$ 3, 00,000
= $ 420,000
The formula for calculating the NPV is as below;
Where:
Ct = net cash inflow during the time t
Co = total original outlay costs
r = discount rate, and
t = number of time periods
If the Company receives the contracts from the Argentinean government, the project will generate a total revenue of $600,000 within a period of one year at an 18 % discounting rate. All the other factors remain constant.
The NPV is calculated as follows;
NPV= (($ 600,000 / (1+0.18)) -$ 300,000
NPV= ($ 600,000 / 1.18) – $ 300,000
NPV=$508,474.58 – $ 300,000
NPV=$ 208,474.58
If Zircon gets into the contract with the Argentinean government, the project will generate $ 208,474.58 as obtained from the NPV above.
The formula for calculating the NPV is as below;
Where:
Ct = net cash inflow during the time t
Co = total original outlay costs
r = discount rate, and
t = number of time periods
Revenue converted to $: ARS 3000,000 x 0.12= $360,000
However, if the contract is not awarded by the government, an excess amount would be paid to offset the ARS 2,000,000 due to the change in Peso rate. Calculated as below;
Offsetting forward sale= ARS 2,000,000 x $0.13 = $260,000
Excess forward sales proceeds= ARS 2,000,000 x $0.12 = $240,000
Loss from forward sales = $260,000- $ 240,000 =$ 20,000.
Cash flows- Loss= $ 360,000- $20,000
= $ 340,000
If the Company does not receive the contracts from the Argentinean government, the project will generate a total revenue of ARS $ 3,000,000 within a period of one year at an 18% discounting rate. All the other factors remain constant.
The NPV is calculated as follows;
NPV= ($340,000 / (1+0.18)) -$300,000
NPV= ($340,000 / 1.18) -$300,000
NPV= $ 288,135.59-$300,000
NPV=$ -11,864.41.
If Zircon does not get into the contract with the Argentinean government and chooses to supply its products to the Argentinean firms, the project will generate a negative NPV of 11,864.41.
Hedged portion: ARS 3,000,000 x $0.12 = $360,000
Unhedged portion: ARS 2,000,000- $0.13 = $260,000
Total= $620,000
The net present value of the zircon company after pursuing the alternative option after hedging the minimum peso revenue is as shown below.
Where:
Ct = net cash inflow during the period t
Co = total original asset costs
r = discount rate, and
t = number of time periods
The NPV is calculated as below;
NPV= ($ 620,000 / (1+0.18)) – $3300, 000
NPV= ($ 620,000 / 1.18) -$300,000
NPV=$525,423.73- $300,000
NPV= $ 225,423.73
Therefore, the alternative strategy, will generate the net present value of $ 225,423.73 if the Company choose to invest in it.
NPV = $360,000/ (1.18) – $300,000
NPV=$305,084.75-$300,000
NPV= $ 5,085.
|
Options |
NPVs |
|
Does not get the government contract |
$ -11,864.41 |
|
Gets the government contract |
$ 208,474.58 |
|
Alternative Strategy (Government Contract) |
$ 225,423.73 |
|
Alternative Strategy (No Government Contract) |
$ 5,085 |
After considering the three options, i.e., failure to get the government contract, successfully getting the government contract and alternative strategy, the Zircon Company should choose the best option that would yield the maximum profitability. From the comparison table above it is evident that the alternative strategy option would generate the highest net present value based on the ratios above. The option has the highest NPV of $ 225,423.73. Alternatively, if the company successfully enters into the contract with the government, the NPV would be $ 208,474.58. If the company does not get the contract from the government and chooses to sale the technology to the Argentinean firms, the lowest NPV of $ 5,085 would be realized (Drury, 2004, p. 78).
The three options should be treated as mutually exclusive events. The most profitable option should be chosen in this case. To maximize its revenue, the Zircon Company should choose the alternative strategy option. Failure to obtain the government contact would yield the least income because it had the lowest NPV (Blocher, et al., 2009, p. 75)
As the financial manager of Zircon, describe the uncertainty that surrounds the estimate of future cash flows from the perspective of the US parent.
Several factors should be considered before venturing into a foreign market. There are risks and uncertainties involved in creating a market for any product or services in the foreign market. There is the need to conduct a thorough feasibility study of the market before making an entrant. Even after making an entrant it would be difficult to estimate the products’ demand level with certainty. In the case of Zircon Company and its entry in the Argentinean market, factors such as economic factors, political factors, technological advancement, and competition will affect future cash flows of the company not only in the foreign market but also for the parent Company (Coleman, 2011, p. 66).
The first factor under the economic factors is the demand and supply. Considering that company would also choose to sell its product to the technological firms, the demand, and supply of the Argentinean technology market would play a major role in the success of the product. Considering that similar products already exist in the market already, the company might be forced to lower its prices further to be accepted by the consumers. In such a scenario, the future cash inflows would be lower than expected (Lindgreen & Hingley, 2012, p. 33).
The second factors are the fluctuating ARS’ exchange rate. The future exchange rate for the ARS is anticipated to be unstable. From the information on the ARS’ conversion into US dollar, in the beginning, the spot rate of the peso is US$0.14. One year later, the spot rate is expected to decline to US$0.12 although the company hopes that the conversion rate is US$ 0.13 (Shu, et al., 2016, p. 61).
The fluctuating exchange rate of the ARS is caused by the forces of demand and supply in the international finance market. For instance, when the value of importing country’s currency becomes volatile over a period it would have an impact on the currency of the exporting country. In this case, the ARS is expected to depreciate against the US dollar for a long time. Therefore, certainty assumption should be taken on the expected future cash inflows. However, the assumptions cannot be made with certainty because of anticipated future risks (Arnold, 2014, p. 55).
There are several factors involved in the political factors. First, some laws applied by the importing countries greatly impact the ability of a foreign company to conduct business. For instance, some countries prohibit a foreign company from owning over 49% of the business shares. Others require the firm to form a partnership with the government or local investors to operate. Such laws affect the future cash inflows. The second factor is the taxes. High taxes on foreign companies makes it difficult to make a considerable profit from selling its products and services. High taxes also make foreign companies less competitive in the market as compared to the local companies (Lucarelli, 2011, p. 101).
The Third factor is war and political instability. Wars have a major effect on companies operating in foreign countries. Businesses can be extinct overnight in case war erupts. A good example occurred when the revolution broke in Libya. Likewise, political unrest also affects the ability of a company to succeed in a foreign country. Both wars and political unrests plays have a major impact on revenue generation for any company (Crouhy, et al., 2014, p. 89).
Investors also shy away from investing in countries facing political unrest. Likewise, decision-makers cannot form a formidable decision on whether or not to proceed with the project without a clear picture of the market. The confidence of the stakeholders is also affected by political unrest and wars. Stakeholders are motivated when the environment always them to give their maximum. Political unrest and wars reduce the ability to generate maximum revenue which adversely affects a company’s profitability (Kržanovi?, et al., 2015, p. 112).
The advancement of technology also has a major effect on the demand for products of a company. The Zircon Company should take advantage of technological advancement to differentiate its products from those of the competitors. The products can easily be differentiated to fit the consumers’ tastes and preferences. However, without the required technology infrastructure, any company cannot survive in the in the stiff technological industry. To have a competitive edge, a company need to invest in aggressive promotion to maintain or create a market share. Aggressive sales come with an extra cost which directly leads to an increase in the product price. Subsequently, the demand and sales of the product in question would reduce hence affecting the future cash inflows (Leung, et al., 2014, p. 67).
Another factor to consider is the level of competition in the target market. The number of real competitors, the degree of competition and existing products in the market, will help the foreign company in planning its marketing and promotional strategies. Where aggressive competition exists, a new company will have to incur more cost to win over consumers compared to when the level of competition is low. The degree of competition directly impacts the amount of revenue and profitability of any company (Kamiya, et al., 2007, p. 58).
Several exposure and risk factors should be taken into account when deciding no whether or not to proceed with the project.
The transaction exposure is the first risk for the Company’s decision to invest in the Argentinean market. Transaction exposure is defined as those risks faced by those companies involved in the international trade. It arises from the fluctuating currency exchange rates after a company has engaged in financial commitment. Transaction exposures can result in adverse losses for companies. The exposure can be managed by hedging both the upside and downside risks. The strategy is aimed at reducing revenue variability and eliminating the impacts of risks associated with exchange rates by using the forward contracts (Lind, et al., 2013, p. 80).
The economic exposure should also be considered. This type of exposure arises from the un-anticipated fluctuation of a currency value which affects an entity’s future cash flows. Economic exposure has a substantial influence an entity’s market value. The exposure has a long-term effect making it so impossible to be hedged easily because it is time-consuming and costly. In the case of Zircon, the exposure arises from the unexpected fluctuation of the exchange rates in the Argentinean market which affects the contract value during the execution (Newton, 2013, p. 77).
Considering that the both the currencies, i.e., the US dollar and the ARS are likely to depreciate in the future, the Pricing policy should be used. For instance, the International Fisher Effect (IFE) Theory is applied in establishing a nation’s nominal by considering the inflation and interest rates. Nominal is recognized by deducting the inflation rate from the normal interest rate. The nominal interest rate should be adjusted by the changes in the expected inflation rate if the real interest rate remains constant over time.
When applying the IFE theory, first, the fisher’s effect should be used to calculate the expected rate of inflation for the respective country. Second, Purchasing Power Parity (PPP) theory is used in estimating the variation in the anticipated inflation will influence the exchange rate (Rejda & McNamara, 2013, p. 73).
Considering inconsistency of the real interest and nominal interest, the Fisher theory is affected by the error. Zircon Company should rely on the market share and the expected profit margin by choosing the price likely to maximize the profits.
Diversification of the operations would assist in minimizing the effect of exchange rate risks on the future cash flows. Diversifying activities ensure that the risk associated with exchange rate exposure is reduced symmetrically. Diversification of the operations would generate a natural hedge technique that maintains a steady cash flow of the dollar even if the exchange rate fluctuates.
Moreover, with flexible operations, the company will have the ability to choose favourable currency movement paths to ensure that the profit is maximised. Flexibility also ensures that the unfavourable movement of currencies is minimized. The strategy would lead to increased protection as well as adding option value. To assess Zircon’s exchange rate and economic exposure’s the regression analysis should be used in analyzing the historical exchange rate and cash flows data’s (Beullens & Janssens, 2014, p. 78)
The third kind of the exposure is contingent. Zircon is exposed to contingent risk when negotiating or bidding for contract or projects in the foreign markets. Contingent exposure arises from the economic exchange and transaction risks before getting the contract with the government.
The translation exposure would also affect the company when it comes to translating the financial reports, arising from the contract transaction into the consolidated report, at the parent company. While the translation exposure does not affect cash flows directly, it influences the reporting of the assets, liabilities, earnings and the stock price obtained from the foreign market (Kamiya, et al., 2007, p. 90).
The translation exposure can be managed by conducting hedge on the balance sheet. The hedge will help in iron the differences on the balance sheet arising from the net assets and liabilities as a result of the movement of the exchange rate. Therefore, the company should establish an appropriate amount to balance the assets and liabilities. Foreign exchange can also be used to hedge existing derivatives arising from the exposure (Kamiya, et al., 2007, p. 91).
The Operational Risk Management refers to activities that involve risk evaluation which is addressed in a cycle. The activities within the cycle comprise of risk assessment, decision-making and implementing the risk control mechanisms. In most cases, risk management entails failed internal systems or processes, external events, and human errors (Newton, 2013, p. 102).
The ORM model is acceptable due to the numerous benefits associated with it. For instance, business is likely to reduce its operational loss, detect and rectify unlawful operation, reduce the auditing and compliance costs, and reduce the exposures likely to generate risks in the future.
According to the net present value technique, the contract is justified, and the company should proceed with investing in the contract with the government. The decision is based on the positive NPV to would be realized. However, being a financial investment other forms of risks are likely to arise. For instance, if the Argentinean government changes its law and regulations governing its business relationship with foreign companies, operations of the Zircon Company would be affected. Likewise, the operations might be tempered with if the Parent Company in the U.S. changes its opinion on the contract (Newton, 2013, p. 105).
Standard deviation or variance technique is used in assessing the financial risk. In foreign currency exchange, companies have interested the rate of change that exists between different currencies. Greater currency/ financial risk occur when the variance or standard deviation is high.
To determine the outcome on returns and distribution of returns associated with financial risks, the Value at Risk (VaR) is used. Using the VaR technique, the probable amount that is likely be lost from an investment over time is determined and used for mitigation purposes.
From the anticipated loss, the Zircon should insure itself from the financial risks listed above. The insurer will have the best opportunity to effectively evaluate the risks associated with the proposed investment. The insurance option will also provide safety measures to the company. However, seeking the services of the insurer to increase operating cost for the company reducing its earnings (Rejda & McNamara, 2013, p. 111).
Conclusion
The Zircon Company have already obtained substantial financial information showing the project is viable from the positive financial outcome posted by the NPV. However, the company should also evaluate and analyze the operational and financial exposures and risks associated with the project. A detailed risk analysis will provide the company with adequate information on whether or not to proceed with the project.
References
Horngren , C. T., Datar, S. M. & Rajan, M. V., 2011. Cost Accounting: A Managerial Emphasis. New Jersey: Prentice Hall.
Arnold, G., 2014. Corporate financial management. 1 ed. New Jersey: Pearson Higher Ed.
Beullens, P. & Janssens, G. K., 2014. Adapting inventory models for handling various payment structures using net present value equivalence analysis. International Journal of Production Economics, Volume 157, pp. 190-200.
Blocher, E., Stout , D. & Cokins, G., 2009. Cost Management: A Strategic Emphasis. New York: McGraw-Hill/Irwin.
Coleman, T. S., 2011. A Practical Guide to Risk Management. New York: Research Foundation of CFA Institute.
Crouhy, M., Galai, D. & Mark, R., 2014. he Essentials of Risk Management. New York: McGraw-Hill Education.
Drury, C., 2004. Management and cost accounting. Singapore: seng les press .
Drury, C., 2015. Management and Cost Accounting, New York: Cengage Learning EMEA.
Kamiya, S., Shi, P., Schmit, J. & Rosenberg, M., 2007. Risk Management Terms. University of Wisconsin-Madison: Actuarial Science, Risk Management and Insurance Department.
Kržanovi?, D., Kolonja, B. & Stevanovi?, D., 2015. Maximizing the net present value by applying an optimal cut-off grade for long-term planning of the copper open pits. Acta Montanistica Slovaca, 20(1), pp. pp.49-61.
Leung, B., Springborn, M. R., Turner, J. A. & Brockerhoff, E. G., 2014. Pathway?level risk analysis: the net present value of an invasive species policy in the US. Frontiers in Ecology and the Environment, 12(5), pp. 273-279.
Lindgreen, A. & Hingley, M. K., 2012. Value in business and industrial marketing: Past, present, and future. Industrial Marketing Management, 41(1), pp. 207-214.
Lind, R. C. et al., 2013. Discounting for time and risk in energy policy, New York: Routledge.
Lucarelli, C., 2011. Risk Tolerance in Financial Decision Making. Washington: Palgrave Macmillan Studies .
Newton, P., 2013. Managing Project Risk. New Jersey: Bookboon.com.
Rejda, G. E. & McNamara, M., 2013. Principles of Risk Management and Insurance. Paris: Pearson Series.
Shu, S. B., Zeithammer, R. & Payne, J. W., 2016. Consumer Preferences for Annuity Attributes: Beyond Net Present Value. Journal of Marketing Research, 53(2), pp. 240-262.
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