What is risk analysis on investment decisions?

Answer 1

The main objective of any company is to maximize shareholder's wealth. The main way companies achieve this objective is through investments in real and financial assets. A company looks at various external strategies which include Mergers and Acquisitions as well as internal strategies such as increasing production from within. Before making a final decision on what type of assets to invest in or what strategy should be used, a company should apply various valuation techniques to these projects or proposals in order to see which project adds the most value to the company.

External Investment Strategies

Like all successful technology companies Silicon Arts Inc. (SAI) has goals to increase its market share and keep pace with technology. SAI has two proposals that could afford them an opportunity to accomplish both of these goals. The first proposal is to expand their current market share in the Digital Imaging semiconductor industry (Apollo Group, Inc., 2008). The second proposal is to enter the Wireless Communications Industry (Apollo Group, Inc., 2008). These proposals are similar to the proposals offered to Lester Electronics Inc. (LEI) and unfortunately, taking too much time to decide could cost millions of dollars in revenue. Like LEI, SAI should conduct capital budgets evaluations on both companies.

SAI and LEI could use several methods to access the risk level associated with each proposal. The first method is the Net Present Value (NPV) method. This method measures the surplus or insufficiency of the project's cash flow. This is done through the use of the cash flow statement. Basically, the invested amount is added to the net cash flow (over the lifespan of the project) and divided by the discount rate. If the result is a positive number then according to the NPV rule the project should be accepted. This is probably the most used method because it takes into account all cash flow including depreciated assets and liabilities. The next method to consider is the Payback Period method which is normally used by big corporations when making small financial business decisions. Under this method the interested company sets a payback period date and if Project X can pay off all associated debt by that set date then the project should be accepted. Unfortunately, this method can be misleading since it only considers the cash flow as of the payback period date. It does not factor in if Project X has a higher cash inflow earlier than Project Y. Next is the Average Accounting Return (AAR) method, which "is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life" (Ross, et al., 2004, p. 149). The project should be accepted if the AAR amount does not exceed the targeted accounting rate. The flaw with this method is that it does not take into consideration depreciation values. This method only considers the book value of assets and the net income. Unfortunately, assets do depreciate and lose value over time which could affect cash flow. The last method to consider is the Internal Rate of Return (IRR). The IRR uses the same formula as the NPV method except the outcome would show what the expected return rate percentage will give a NPV value of zero. In order to accomplish this random percentages are input into the equation until the goal is reached. Once the correct expected return rate percentage is found the percentage becomes the IRR. As long as the IRR is greater than the expected return rate percentage a company should accept the project. While the IRR method is very similar to the NPV method, it does present several problems when used in complicated situations.

After researching several valuation techniques the suggested method used to determine risk level associated with each proposal was NPV. After putting in the net cash flow figures and discount rates for Digital Imaging and Wireless Communication, the data reveals that Digital Imaging has the higher NPV and thus expanding market shares within the Digital Imaging semiconductor industry would add the greatest value to SAI.

NPV

IRR

PI

Dig-image

17,370

34.70%

1.45

W-Comm

8,673

30.30%

1.32

Cultural Values 1

Internal Investment Strategies

Silicon Art, Inc. (SAI) is a 4-year-old company that manufactures digital imaging Integrated Circuits' (Apollo Group, 2008). Lester Electronics, Inc. (LEI) is a distributor of electronic capacitors and is a publicly traded company (Company Overview, 2008). Both companies are facing growth issues in their individual markets. Even though SAI and LEI have similar issues that apply to growth they can only be compared in generalized terms. Both companies need to increase profit and market share and decrease overall cost of capital. SAI wants to reinvent itself by expanding the existing market or by entering a new market with their existing chip prototype. LEI is in the initial defense of a takeover bid from a rival company. Both companies must make some difficult decisions that will affect their company's longevity and continued viability.

A few avenues both companies might use may provide short-term solutions for their problems. The cost of equity capital could be distributed to the shareholder as dividends keeping in mind that this may not be an urgent need for SAI since profit and market share are not in current decline. However, for LEI this tactic may provide some short-term solvency for their company (Ross, et al., 2005).

Both companies need to decide whether to continue to sell raw materials in the form of integrated circuits and capacitors or to initiate processing material into finished products. SAI and LEI have made financial inquiries into committing their companies to accomplish this endeavor. The constraints for this model must be analyzed prior to total company commitment. The constraints for each company may be similar for net cost of capital investment but are entirely different in model design. Both companies will need to identify the critical or limiting resource for their individual company. SAI will be limited by its ability to gain financially if a comparable product floods the existing market while in preparation stages. LEI will lose market share if its supplier of capacitors, Shang-wa, does not continue to provide the capacitors that it distributes. These decisions are generated by expected sales volume and profitability for the companies. The beta, or difference, of expected market return for new projects is similar to the firms existing returns (Ross, et al., 2005).

To determine beta in real life situations it must be estimated using the standardized covariance of a return on the market portfolio. The beta is obtained by multiplying the deviation of each company's general return by the markets return. Keep in mind that betas vary over time and change financial leverage with business risk (Ross, et al., 2005). The beta of either of these companies is dependent of several factors; cyclicality of revenues, operating and financial leverage. In addition, remember that beta may not fit either company for initiating a new project for their existing industries. SAI owns land that they are unsure of what to do with it. The option to build a factory, buy machinery, and hire employees exists, but the question lingers of what becomes of the land factory, and employees, after the project is complete. The opportunity exists to rent or lease the land to someone else and use the money generated for investing in other areas of the company. No matter what decision is made, opportunity costs are ever present. SAI has to determine whether opportunity costs is more profitable to proceed with their project then try to figure out what to do with the land factory, machinery, and employees, or if leasing the land will generate a better return.

In the real business world, events may not perform exactly as planned. Most decision makers hedge their plans by using quantitative risk management theory. Any deviation from the proposed plan or expected outcome of the plan will have been thought out before initiation with alternative plans in case of fallout. An example would be of plans to manufacture capacitors or digital communication devices. Even if the forecasted yield and risk have been analyzed and measured against industry standards, there could be a scenario where both of these products have flooded the market. The expected yield, value forecast, and forecasted results of each will not yield successful results for either company. To obtain a better advantage the standard deviation is a useful tool for measuring risk when data is normally distributed. The standard deviation can be used to forecast the probability of certain business outcomes.

The reliability of the forecasted increases in sales has to be determined. World Communications or Digital Image may have a higher forecasted sales increase, but have a much higher risk associated with the potential sales increase. World Communications' IC 1043 chip is only compatible with 2.5 G technology for mobile telephones, but the 3 G generation is threatening to become prominent. The introduction of 3 G technology would most likely decrease the sales of the 2.5 G technology so the risk is higher that the forecasted sales are off. Digital Image supposedly has a tough, competitive market making the forecasted sales risky.

SAI and LEI would benefit by having a complete analysis of their company's risk, projected plans to reinvent their industry and net cash flows. Benchmarking within their industries for a more accurate view of their company's positions and individual values could shed important objective detail toward success. Each company can maintain and review its balance sheet. A balance sheet is a financial list of a company's assets and liabilities. The assets are listed on the balance sheet in order of liquidity, which is the ease at which the assets can be converted to cash at a fair price and the time it takes to do so (Ross, 2005). In SAI's case, the decision to use its empty land or to rent is a question. SAI has to determine what the liquidity of the factory and its machinery would be at the end of the project or if it could be used for another project. Depending on the liquidity determined, it may be better financially to rent the land out and avoid having to deal with the factory and other assets. LEI wants to build a new factory in Asia, which would expand its market. However, with cash flow restrictions, investing alone would be difficult, thus the reason for the acquisition of Shang-wa.

An example of benchmarking is the Kmart chain stores, which are truly a success story in the business community. The company has survived a devastating Chapter 11 bankruptcy in 2001 to re-organize the company structure. Everything from marketing agency changes to retail products were reviewed and re-structured to increase their marketability with increasing stock options for shareholders as the motivating factor. Kmart has introduced new product lines, and re-issued stock to revamp it sagging financial statements for 2001. As part of the primary focus, intent on moving forward, the retail end of the business will reduce costs and enhance asset productivity (Kmart, 2004).

No company would purposefully neglect the mandatory work that is required to be successful. Best case for both companies would include successful outcomes on their decisions toward becoming self-contained ventures. Manufacturing and distributing their products in markets that demand them will prove that a well thought out plan of action is paramount to increased profits.

Investment Risk

Risk is inherent in conducting business. While some investments are safer than others no one can guarantee that a particular venture will be profitable for a firm. Even with extensive market analysis and detailed revenue projections, external and internal factors can arise that can change a seemingly profitable project into a loss. The company must decide whether it should expand the existing digital imaging market or enter the wireless market. A critical part of choosing projects for a firm is determining the risks for each project. In the simulation, many of the risks arise from investments SAI will need to make per each proposal. Many parallels can be drawn between SAI in the simulation and LEI in the scenario.

Digital Imaging

Many risks are associated with SAI decision to expand into the existing Digital Imaging Market. The main investment risk for this proposal lies in the new plant and equipment the company will need to build and purchase at $40M in order to expand production by 10,000 chips a day to equal 30% potential revenues in five years. This decision is risky because of the existing competition in this market. Forecasts predict that competitors may force a decrease in sales volume of up to 5%. If the project is unprofitable, the company will have a new facility on its hands as well as equipment that it does not need due to a decrease in demand. There could be many problems if the market growth, projected at 20% in the first year, is inaccurate or affected by external sources. LEI is in the same position if it merges with Shang-wa and builds a new manufacturing plant in Asia at $60M. The expectation is a 28% increase in production units of aluminum electrolytic and film plastic at a revenue value of $14M.

The outcomes from Chairman Hal Eickner for SAI were to increase market share and keep pace with technology. As with LEI, which holds 64% of the US market and is challenged to grow cross-border business in the Asia marketplace where they only hold 1% in manufacturing and distribution, SAI holds 70% US market share. The expectation and risk for SAI is that the South East Asian market is growing the fastest and is ripe for expansion. The Web site for Business Link (2008) states to increase market share a business has to take customers from its competitors or attract new customers. Achieving this requires a thorough understanding of both the existing customer base and that of rival businesses.

As mentioned above, the SAI market share in the Digital Imaging IC segment is at risk because of expansion from competition with comparable products. One of SAI's competitors is a company named T and T. This company is working on a lower cost IC Version Chip that is scheduled to launch the same year as SAI. This will definitely affect SAI's expected sales volumes of 5% in years one, two, and three. Because of this risk SAI investors will be looking to increase there expected return on investment (ROI) from 17% to 19%. From benchmarking analysis LEI and Shang-wa is comparable to NetSuite and Tako Ventures because both situations must decide how to pay off debt to keep pace with the competition.

SAI will need to monitor the expected risk to develop the new IC-1032 chip used in data mobile phones. In 2001, revenues fell 40% due to industry slowdown, reduced costs, and capital expenditures. Expected revenue growth for the chip is 20% first quarter 2002, and 7% the next two to five years. The new plant in Sunnyvale, CA. will generate 30% of the revenue over five years with the capacity to produce 10,000 chips per day. Estimated sales will help off-set the capital expenditure of $40M to build the new plant. The Net Present Value (NPV) indicates the value of an investment that will bring to a company. SAI has a positive NPV, which should be accepted. This includes the opportunity costs to other available investments like W-Comm. Looking at sensitivity analysis, which examines how sensitive a particular NPV calculation is to changes in underlying assumptions (Ross, et al., 2004).

Conclusion

SAI and LEI are both faced with difficult decisions. Each company realizes the need to expand; otherwise their competitiveness will decrease potentially leading to closing. Each company must analyze its cash flows to determine if it can financially afford buying another company or how much can be invested in the company. Looking at the return rate also plays a significant role in how much can be spent. The sooner the money can be recovered, the more money there will be available to be invested or spent. SAI is faced with the reality that their 2.5 G chip may become obsolete soon. Research and development or acquiring a company to add a new product to their repertoire there are two options available. SAI could renovate their vacant land for a new project, but may be stuck with the factory and assets without a use for them. The other option would be to lease the land increasing available funds for buying another company. LEI is either going to buy Shang-wa and build a new factory in Asia to expand its market, or sell to Avral. If Shang-wa is bought out by a competitor, LEI would most certainly be forced to sell to Avral since revenue would drop off by 43% without Shang-wa as a supplier. If SAI does not make a move to increase their technology, they too will lose ground in the market to competitors. LEI and SAI have to make some move of investing. Their cash flow, rate of return, net present value, and risk associated with each endeavor all play a role in the final decision made.