Assessing Investment Risk Across Three Business Plans

Introduction: Risk Assessment in Investment Decisions

The way an investment is assessed will include consideration for the level of risk present in that investment. The higher the risk associated with a business, the higher the required reward — a principle known as the risk-reward equation. Where the risk premium increases, this will also lead to the use of higher discount rates in discounted cash flow assessments, such as net present value (NPV) calculations. In order to consider how this may be applied to investment decisions, three different business plans are assessed: Acme Consulting, Interstate Travel Center, and Silvera and Sons.

Risk may be assessed using a number of different criteria. From the perspective of an investor or lender, the key aspect of risk is determining whether the money invested or loaned will be returned and whether it will generate a profit sufficient to justify the risk (Berry, 2012). This also incorporates an assessment of the viability of the business and its potential financial returns (Reilly and Brown, 2011). The aspect of opportunity cost may also be considered, as an investment in one company may represent risk in terms of the potential returns that might have been gained elsewhere when investments are mutually exclusive (Nellis and Parker, 2006).

Acme Consulting

The first of the firms is Acme Consulting. This is a start-up firm offering premium consulting services to large high-tech manufacturers, such as IBM and HP, and a secondary market of medium-sized media businesses, with a head office in the renowned Silicon Valley area — placing the firm in a strategically important location. The firm is being established by individuals with relevant knowledge in marketing a consultancy as well as the high-tech industry. It is noted that the market for these services is currently fragmented, which may provide opportunities. With related diversification of services — including retainer work, market research, and project consulting — the firm will be able to offer a full package. Sales patterns are expected to vary over the course of a year rather than remain level.

The financial aspect of the firm is very important when assessing risk (Reilly and Brown, 2011). The company requires a relatively small level of capital investment compared to the other two cases, and on an operating basis will break even in the first year (during month 9, calculated using operating profit). However, profit within the first few years is relatively low: it is minimal in year one and, although it is increasing, by year three the net profit reaches only $65,000, equating to a 6% profit margin. This limits the potential return on investment for investors.

Risk assessment must also consider the potential security the firm may provide. A key concern with Acme is the low level of physical assets being created, which offers little physical security for any investment. In terms of legal risk, it should also be noted that the firm has not yet been incorporated; as such, any agreements between the firm and an investor may carry additional risk, since the firm does not yet have its own legal personality. Overall, Acme may be using only a small level of capital, but it is creating limited assets as security and generating constrained returns. The current start-up status of the firm — which is yet to be incorporated — adds further risk.

The Interstate Travel Center involves the development and subsequent operation of services and amenities for truck drivers, including gas sales, a convenience store, and restaurants. The location will be on a busy interstate where there is a high level of potential passing trade with only limited local competition. There is also potential for further growth through the development of a "Port to Plains" corridor increasing traffic to the location, though this is not assured and therefore should not be weighted heavily in the assessment.

Interstate Travel Center

The plan benefits from the essential nature of many of the services offered and the lack of nearby competition. The experience of the couple establishing the business is also a positive factor. However, as with Acme, this is a start-up business with no operational track record. There is also a concern in the projections: the estimated gross profit margin is 26%, which is 10% higher than the industry average. This may reflect superior positioning, but it may also indicate overly optimistic projections. The wide range of services offered could partly explain the higher margin.

The financial performance projections indicate that the firm should generate an operating profit from the first year. A key difference between Acme and Interstate Travel Center lies in the capital structure and asset base. The Interstate Travel Center is taking on a high level of long-term debt, with $2.5 million of the required $2.75 million in the form of a loan. The firm will also have greater security through the purchase of assets such as land and the development of the service station. However, it should be noted that despite these assets, a loan of this size is likely to be secured and will take priority over money owed to equity investors.

As a start-up business without a history in this specific industry, the Interstate Travel Center may still be considered risky. Unlike Acme, however, it involves the creation of a physical business with a higher level of tangible assets.