INTERNAL REPORT. FIXING RISK, UNCERTAINTY AND CASH FLOW DISCREPANCIES
In making investment decisions we are dealing with; and actually shaping; the firm's future, but the future is not certain and investment decisions, whether personal or corporate, are invariably undertaken with imperfect knowledge about the future. The future may turn out to be better or worse than expected. For the corporate firm, the objective of an investment decision is to allocate resources only to those projects which will preferably increase, or at least maintain, the firm's value and the wealth of its shareholders. Clearly it would not make good financial sense to invest in projects which would reduce corporate value (Ang, 2002).
The problem for managers is that at the outset it is often difficult to determine which of the firm's potential investment projects will enhance corporate value and which will diminish it. Consequently when making investment decisions investors and managers have no idea which projects will succeed and which will fail, which will be peaches and which will be lemons! Such decisions inevitably involve an element of risk, the key investment characteristic with which we are concerned in this thesis (Levy, 2000). So how can a firm's managers take account of risk in the investment appraisal process? It is, important to bear in mind that risk analysis is not an exact science; there is no perfect answer to dealing with risk in investment decision-making (Bolton, 2007). The techniques which are presented in this report will certainly help managers and investors analyse and evaluate risk, but they are aids to decision-making. They do not eliminate the need for the exercise of judgement on the part of the decision-maker(s), and the more complex the investment decision, the more significant will be the role of managerial judgement.
Before proceeding it will be helpful to clarify some terminology. Although the terms risk and uncertainty are in practice often used interchangeably, there is a slight distinction among them.
Risk and Uncertainty
Generally speaking, risk can be defined as: the chance that the actual outcome will differ from the expected outcome. Risk is frequently measured in statistical terms by the standard deviation, denoted by ? (the Greek letter small sigma), which is a measure of dispersion or spread around an expected or mean value, assuming a normal distribution of returns. The greater the degree of dispersion ? around the mean, the greater the degree of risk (Boyer & Roth, 1978). In attempting to quantify risk we are concerned with measuring dispersion, good and bad, on either side of an expected value, as the greater the overall variability, the greater the risk and the greater the perceived risk, the greater the return investors will require.
There are three different types of project risk to be considered:
This is the risk of the project itself as measured in isolation from any effect it may have on the firm's overall corporate risk. Stand-alone risk ignores the possibility of risk diversification when the project is combined with the firm's other projects (Walker & Petty, 1986).
Corporate, or within-firm, risk
This is the total or overall risk of the firm when it is viewed as a collection or portfolio of investment projects. An individual project's corporate risk is a measure of the project's contribution to the total riskiness or variability of all the firm's cash flows. A new project may add to or reduce the firm's corporate risk, that is, it may increase or decrease the firm's total cash flow variability.
Market, or systematic, risk
This defines the view taken of a project's risk by well-diversified shareholders and investors. Well-diversified shareholders will accept that the project is just a single asset within the firm's overall portfolio of assets and that their own shareholding in the firm is only one part of their own well-diversified investment portfolio. As we know from our study of risk and return, market risk is essentially the stock market's assessment of a firm's risk, its beta, and this will affect its share price v. Shareholders who are not well diversified are likely to be more concerned with corporate risk than with market risk (Levy, 2000). Similarly, if the firm is a small business the owner-managers will be more concerned with corporate risk.
In practice both corporate and market risk are extremely difficult to quantify. It is a comparatively easier task to quantify a project's stand-alone risk, and use this as a surrogate measure for corporate and market risk. If, for example, an individual project's stand-alone risk is perceived to be higher than the firm's 'normal' or average risk project, this is likely to raise the level of corporate risk and consequently market risk. The three types of risk are in fact correlated (Walker & Petty, 1986). Because of the practical difficulties of measuring corporate and market risk, and the correlation between the three different types of risk, we will accept stand-alone risk as a suitable substitute for corporate and market risk.
Dealing with Risk
In dealing with risky decisions, three stages can be identified (Bolton, 2007):
1 Recognition of the risky situation.
2 Evaluation of the risky situation. Are the risks considered acceptable? Is it worth staying in, or entering this situation? Would it be better to opt out, or stay out?
3 Adjusting the risks. Managers who have a positive attitude to risk, that is they are risk-seekers, will try to shape the situation to their advantage by stalling for time and more information and by seeking control.
It should be appreciated that here we will be using these techniques essentially to analyse a project's stand-alone risk.
Scenario analysis extends sensitivity analysis by creating a range of different business case scenarios: its focus is much broader than simply evaluating individual variables one at a time. Typically three broad scenarios will be produced; a best case scenario, a middle (or most likely) case scenario, and a worst case scenario (Boyer & Roth, 1978) the BMW approach. In each case, an estimate is made of the project's most likely outcome (in terms of its NPV or possibly IRR), given each scenario's particular set of assumptions and variables. For example, under the best case scenario, managers will be required to make optimistic or favourable assumptions about business conditions (e.g. economic, marketing and competitive conditions) and about the key variables (Levy, 2000). Typically higher estimates will be made for selling prices and sales volumes, and lower estimates for unit costs, initial outlay and so forth. For the worst case scenario more pessimistic assumptions and estimates will be made.
Scenarios can be 'hard', in the sense that they rely solely on hard, quantitative information, such as financial numbers and economic statistics. Alternatively they can be 'soft', meaning that they are derived from qualitative, descriptive information. Clearly they can, and should, comprise a combination of both (Bolton, 2007).
Once a base case, or best estimate, appraisal for an investment project has been completed, sensitivity analysis can be used to test how changes in selected cost and/or revenue items will alter the base case cash flow estimates. Specifically sensitivity analysis involves:
1 testing how the overall expected outcome of the project (measured in terms of its NPV, or possibly IRR in some cases) is likely to alter in response to changes in any of the input variables (e.g. The initial outlay, selling prices, sales volumes, project lifespan, asset residual values and so forth); and
2 identifying the key or critical variables in the base case appraisal. These are the input variables which, even if they change by a small amount, will have a magnified effect on the project's expected outcome (NPV, or possibly IRR).
For example, management may wish to consider the effect on the base case NPV of a 5 per cent increase or decrease in the expected sales volume of a new product. Sensitivity analysis invariably involves asking 'what if?' type questions. Questions such as, what if our sales price is 10 per cent less than expected? What if our raw material costs are 10 per cent higher than expected? For this reason, sensitivity analysis is frequently referred to as 'What if?' analysis. The objective of sensitivity analysis is to determine how sensitive the NPV is to changes in any of the key variables and to identify which variable has the most significant impact on NPV (Walker & Petty, 1986).
If a small change in a key variable, such as sales volume, say less than ±5 per cent, produces a substantial change in the NPV, perhaps even turning it negative, then this would probably be deemed a very risky project. Conversely, if with a large change in a key variable, such as sales volume or sales price, say ±10, or even 15, per cent, the NPV remains positive, then the project may be viewed as low risk. In sensitivity analysis all other variables, except the one under testing, are held constant. So…