Essay on Risk and Investment Decision Making

Fixed Costs

Fixed costs is expected to be 60,000,000 in year one including the depreciation, after which it will increase by 4% per annum. However, there is a need to deduct the annual depreciation amount so as to get the exact value.

Year 1: 60,000,000-36,000,000= 24,000,000.

This new figure is the fixed cost which will now be appreciated by 4%. Therefore, the following years will have fixed costs as indicated in the table below;

Year Fixed costs ()

2 24,960,000

3 25,958,400

4 26,996,736

5 28,076,605

Table 2: Fixed Costs

Investments

The initial investment is 50,000,000. However, this will also increase by 4% per annum as indicated in the table below.

Year Investment ()

2 52,000,000

3 54,080,000

4 56,243,200

5 58,492,928

Table 3: Investments

Amount to Depreciate

This will be obtained by the investment of 200m of in manufacturing equipment and the amount at which the same equipment will be sold for at the end of the five years, which is 20m. Therefore;

=200,000,000-20,000,000

=180,000,000.

To get the annual depreciation amount, this amount is divided by the number of years as shown below;

=180,000,000/5

=36,000,000.

Income before Tax

Year Sales Revenue (a) Production Cost(b) Labor Cost(c) Depreciation(d) Fixed cost(e) Total(a-(b+c+d+e))

1 216,000,000 66,960,000 25,920,000 36,000,000 24,000,000 63,120,000

2 388,800,000 139,104,000 51,840,000 36,000,000 24,960,000 136,896,000

3 291,600,000 120,499,200 43,200,000 36,000,000 25,958,400 65,942,400

4 209,952,000 100,282,522 34,560,000 36,000,000 26,996,736 12,112,742

5 94,464,000 52,199,336 17,280,000 36,000,000 28,076,605 39,077,542

Tax Calculations

Year Income tax Total

1 63,120,000 30% 18,936,000

2 136,896,000 30% 41,068,800

3 65,942,400 30% 19,782,720

4 12,112,742 30% 3,633,823

Net Income Calculations

year Income before tax Tax rate Net income (Income before tax* (1-tax rate))

1 63,120,000 0.30 44,184,000

2 136,896,000 0.30 95,827,200

3 65,942,400 0.30 46,159,680

4 12,112,742 0.30 8,478,920

Year 5 experienced a net loss of 39,077,542.

Total Annual Cash Inflows from Operations

Year Net Income(a) Depreciation(b) Salvage value(c) Cash inflow(a+b+c)

1 44,184,000 36,000,000 - 80,184,000

2 95,827,200 36,000,000 - 131,827,200

3 46,159,680 36,000,000 - 82,159,680

4 8,478,920 36,000,000 - 44,478,920

5 39,077,542 36,000,000 20,000,000 16,922,458

Change in Working Capital Investment

This is achieved through the following formula;

Initial investment (annual investment*1.04)+employee benefits

Year 0

200,000,000+50,000,000=250,000,000

Year 1

50,000,000(1.04)=52,000,000

Year 2

52,000,000(1.04)=54,080,000

Year 3

54,080,000(1.04)=56,243,200

Year 4

56,243,200(1.04)=58,492,928

Year 5

[58,492,928(1.04)]+18,000,000=78,832,645

Calculation of Discounted Cash Outflow

Year Outflow (A) Discounting Factor (B) Net PV of Cash Outflow (A*B)

0 250,000,000 1 250,000,000

1 52,000,000 0.907 47,164,000

2 54,080,000 0.8227 44,491,616

3 56,243,200 0.7462 41,968,676

4 58,492,928 0.6768 39,588,014

5 78,832,645 0.6139 48,395,361

Total Outflow 471,607,666

Calculation of Discounted Cash Inflow

Year Inflow (A) Discounting Factor (B) Net PV of Cash Inflow (A*B)

1 80,184,000 0.907 72,726,888

2 131,827,200 0.8227 108,454,237

3 82,159,680 0.7462 61,307,553

4 44,478,920 0.6768 30,103,333

5 16,922,458 0.6139 10,388,697

Total Inflow 282,980,709

The Net Present Value Calculation

The net present value is calculated using the following formula;

NPV = NPV Inflow-NPV outflow

NPV=282,980,709-460,557,466

NPV= -188,626,958

Therefore, the net present value is a negative figure, meaning that this project is not worth pursuing. The company will be spending more on it, rather than earning returns. The risk, therefore, is too high as no revenue will be earned from it. The company will not have anything to invest in as all its capital will be lost, including any investments made.

Additional factors to Consider

If in any case, the company decides to embark on this project, there are specific considerations it should take. First, there is a need to reduce the operating costs as much as possible by doing away with any unnecessary expenditures. This will ensure that it can save more, hence be able to have some capital left for future activities. Second, this company should consider looking for more investments by partnering with other companies so that it will have more capital to invest. Third, it should consider outsourcing some of the activities thereby saving costs.

Part B: Risk and Investment Decision Making

Introduction

All companies face risks every day. The constantly increasing volatility of the present world economy is what has prompted investors to seek better alternatives when it comes to make investments (Flavia, Elena & Ovidiu 2009, p. 476). In most cases, this is done through the capital budget, which is a form of plan on how the company will engage in long term assets investments (Wadsworth & Cox 2011, p. 44). The risk for assets is generally inevitable; this is why it has all been narrowed down to what can be done to minimize it before starting a project. Therefore, when risk is considered, a company is able to minimize losses. This report features an evaluation of how risk may be incorporated in business investment decision-making process. It supports the argument that risk is incorporated by assessing whether its level is high or low for a given project, thereby influencing the overall decisions made.

How Current Thinking on the Issue has Developed

Previously, risk was considered as something negative that definitely meant not pursuing a project. This mode of thinking, however has evolved as today, risk is seen as an essential factor which is unavoidable, but can be used to determine when a project is worth pursuing (Bosman & Van Winden 2010, p. 453). According to Tengs (2005, p. 141) when making investment decisions, risk and uncertainty are unavoidable due to the possibility of risk. It is an important factor to consider, especially since it leads to decisions that are significant for the sustainability of the organization. Therefore, currently most executives seek ways around risk and uncertainty. Since business executives are often trying to meet multiple objectives with every investment decision made, they will often consider the expected return and take away the riskiness of the project (Bharti, Pragyendu & Sharma 2015, p. 372).

Developments in Business Practice

From various researches, it has become quite clear that investors tend to conceptualize risk and uncertainty differently (Mittal & Vyas 2011, p. 47). This is why the method of coping also varies as it depends with the approach a given decision maker will take. Fortunately, several methods have been identified to assist with considering risk and uncertainty in investment decision making. The first approach is based on the risk premium. This is a model whereby investors will try to avoid the risk as much as possible. Therefore, before they can make any investments, they have to prove that the project returns are much higher than the returns from the less risky projects (Chen, He & Zhang 2017, p. 1740). The second approach is based on the payback period. Here, the expected project cash flow is calculated beforehand. Thereafter, the investors consider the amount of time they need to have their invested money (Bohn & Deacon 2000, p. 535). If it will take a lot of time, then the project is considered too risky to invest in. More approaches such as the certainty equivalent and sensitivity analysis are considered. Investors may decide to use all approaches to ensure they are actually making the best decision that has all risk accounted for (Ho, Lai & Lee 2013, p. 179).

Where Future Advancements can be Made

Advancements have been made in the types of approaches used today as financial projections can now be made. Initially, companies could not take any known risk, but today, they can risk anything as long as the returns are expected to be worth it (Clarke 2014, p. 149). In future, there needs to be advancements in research to help determine the actual consequences of risk and what can be done to overcome them effectively, without having to quit a project midway.

Bibliography

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