Below, different risks are identified and ways to address them mentioned. Please note that this is not an exhaustive list and other risks, both of a financial and non financial nature may be identified in relation to the undertaking of a capital budgeting project by a non financial company.
Uncertainty of Expected Cash Flows Project Sensitivity
While future cash flow projections give a more accurate picture of what will happen with the invested capital in the project, their accuracy is often brought in doubt for their exists an element of future bias, that is, they make predictions about future cash flows based on current or historic estimates and figures. At the same time, while the underlying basis for the projections may be correct, there might be the issue that the impact of this particular variable on overall project profitability might be too high and hence identification and management of it becomes an extreme necessity (Brealy, Myers Marcus, 1992). As an example, consider a firm who is investing in a capital budgeting project in an industry which has low margins and hence a high requirement that successful firms be able to achieve good cost control over raw materials.
In such cases, it becomes imperative that firms are able to utilize sensitivity analysis techniques to identify key variables that would augment special care for the project to meet its profitability estimates. Sensitivity analysis involves bringing about adverse changes in a key variable while keeping other variables constant and looking at the impact of the adverse movement on project profitability (Schweser, 2008). For instance, the cost control example above can be used in a sensitivity analysis by increasing raw material costs by 5 and looking at the impact on project profitability. If profitability falls by too much, this calls for extreme care to be taken in raw material procurement as rising raw material costs exhibit high risk. The advantage of this strategy is that it helps in determining key control areas but does not say anything about the future biased projected values on which the sensitivity is being based.
As an alternative, firms may carry out a Monte Carlo simulation whereby thousands of random figures for key variables are used in a computer simulation to return a normal distribution of Net Present Values with a confidence interval (of 90 to 95) determining where actual NPV will lie (CFA Institute, 2008). This probabilistic assessment of future cash flows removes future bias but its relative complexity means that it is not available for all firms.
It is also interesting to look at project sensitivity from the perspective of the macroeconomic environment whereby the use of scenario testing can be used to link key project variables with the state of the economy and hence look at the effect of changes in the macroeconomic climate may have on project profitability (BPP, 2008). For example, a financial model may incorporate that sales will grow in line with GDP growth. Hence three scenarios can be put forward a fall in GDP growth, a rise in GDP growth and no change in the rate of GDP growth. The respective fall, rise and change in GDP growth if its a cyclical product will help the financial manager understand the link between project profitability and the macroeconomic environment. However, the usefulness of this tool is limited since there may be a problem with the base assumption, that is, the original relationship between sales growth and growth rate in GDP, as in the above case, may be based on historic estimates and hence present a future bias (FTC, 2007).
Project Liquidity
In many cases, capital budgeting projects will need to be looked at from a liquidity perspective as the investors mindset demands a liquidity premium for illiquid investments. Investors and hence management do not want to commit resources to illiquid projects for they put strain on a firms cash flow and hence puts profitability of other projects at risk and hence firm value too (Schweser, 2008). Specifically, two approaches need to be studies here the payback method and project duration.
The payback method is one of the earliest traditional capital budgeting methods and looks at the number of years it takes for an investment outlay to be returned back to shareholders. However, while the targeting of project liquidity is appreciated, it fails to see the important aspect of considering the time value of money, not taking into consideration cash flows after the initial outlay has been recovered and the fact that relativity of projects is not looked into, that is, small projects will naturally have a smaller payback then large ones and hence are not comparable for decision making purposes (CFA Institute, 2008).
So for example, Project A employs an initial outlay of 1000 and returns a payback period of 1 Year as opposed to Project B which employs an initial outlay of 10,000 and returns a payback period of 3 years. Here, the decision criteria is not so simple as the relative initial outlay is high plus the amount of relative profitability is unknown.
Coming to project duration, due to the nature of the time value of money, it is important that projects have positive cash flows over the future periods and that it is preferable that these positive cash flows occur as early as possible. This implies a need for cash flows to be considered over the life of the project when considering project liquidity with the discounting element in NPV calculations taking care of the time value of money aspect. At the same time, commons sizing cash flows over the life of the project in years does not impede on relative bias (as was the case with the traditional payback period approach) for the relative profitability cash flows are also included in the calculation.
Exchange Rate Risks
Firms with international operations primarily have three kinds of foreign exchange risk exposures. These are transaction exposure, translation exposure and economic exposure.
i) Transaction Exposure
By virtue of their international sourcing of raw materials or revenue generating activities denominated in foreign currencies companies find themselves transacting in a number of currencies. Keeping the discussion very simple, one way in which a transaction exposure can arise is where the company inks a purchase or sale transaction with a foreign company denominated in a foreign currency but the payment receipt will be actually effected at some other time (BPP, 2008). Any change in the value of the foreign currency relative to our home currency during the intertwining period exposes us to the risk of over payment under receipt of cash, impacting our cash flows and profitability.
Another way in which transaction exposure may arise is where the foreign subsidiary is dependent upon the parent to finance the local operation. Thus, Nike will have to convert US dollars into Yuan so that the production facility in China can buy the necessary raw material, pay overheads and labor. The goods produced as a result might be sold in the markets of Shanghai only, priced in Yuan. However, if the Yuan was to lose its value relative to the dollar, the parent will find that it received less USD per Yuan (an exchange rate loss). On the other hand, a strengthening of the Yuan will mean less Yuan are needed for purchasing every unit of USD (an exchange rate gain). Although, the favorable movement will benefit the parent company, it is worth pointing out that this lack of certainty about the final amount received from the transaction is also an element of risk as the final return has deviated from the expected value. Similarly, another manner in which transaction exposure may arise is where the foreign subsidiary is not dependent upon the Parent for cash flow but the need to remit dividends back to the Head quarters give rise to such a transaction. A rise in the value of the home currency (Ho) against that of the home currency of the foreign subsidiary (Fo) would mean that the dollar dividend (assuming USD Ho) would be less then the expected dollar dividend that investors were expecting, leading to a fall in the share value (assuming semi strong form or strong form efficient markets).
ii) Translation Exposure
Where companies such as have foreign subsidiaries abroad with assets and liabilities denominated in the foreign currency, a translation exposure will arise when the parent reports consolidated financial statements and needs to translate these assets and liabilities to a common currency which is normally the home currency of the parent (CFA Instititute, 2008). This could result in a fall in the reliability of consolidated financial statements for analysis purposes over time and create uncertainty about the companys net value. Thus, a fall in the value of the foreign currency would imply that in Ho terms the foreign subsidiary witnessed a fall in its net value, even though the company performed exceptionally well as far as profitability, asset generation and financial leverage are concerned.
iii) Economic Exposure
Economic exposure is the degree to which a firm s present value of future cash flows is affected by fluctuations in exchange rates (Brealy et al, 1992). For our purposes, this economic exposure can take the form of a situation where, for example, the exchange rate between the home currency of the company (Ho) and the home currency of our foreign trading partner (Fo) does not vary but the exchange rate between that of Fo and that of another currency, say Eo, in which our foreign trading partner conducts a lot of business, changes. Thus, if foreign subsidiary imports raw material by paying in Eo and Ho and Eo depreciates in value relative to Fo, then the cost of goods sold for Fo will fall and to increase profits they may switch to purchasing from the Eo currency area.
iv) Synthesis - Identification Mitigation
Any presence of cash flows being denominated in another currency leads to the identification of dealing in foreign currencies and hence exchanges rate risk. This is, thus, an automated process. Mitigation of exchange rate risks can come from various sources depending upon the maturity of the firm, the situation and the availability of suitable mitigating instruments. Broadly speaking, firms may enter into forward contracts, future contracts, option contracts or swaps to hedge against transaction exposure. Economic exposure may be managed through the use of business strategy instead of financial terminology while the presence of international accounting standards for consolidating foreign interests reduces the risk of translation exposure. It is imperative for firms considering capital budgeting projects to take into account the impact of such mitigating techniques in the essential capital budgeting analysis when undertaking risk management techniques. However, at the same time, it is also important that the relevant risk management metrics for exchange rate risk management be correlated with the maturity of the firm.
To conclude, the management of any company will have to look out for a wide variety of risks when conducting investment appraisal with a mindset to achieve shareholder wealth maximization. While specific risks can be identified and addressed by virtue of the various tools available, it is important for management to
Relative advantages and disadvantages of each method
Conduct multiple tests
Look at model selection from the point of view of the firm, that is, the maturity and size of the firm must be looked at adhered to.
(Brealy, et al, 1992)
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