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# Investments Essay Example: Risk in Business Investment Decision-making Process

2021-07-15
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1360 words
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A net of the discounted value of cash flows is calculated using the values captured in Appendix A. The calculation features ascertainment of aggregate value of production costs and initial investment is done as captured in Figure 1.

Figure 2 displaying calculation of discounted cash outflow

Outflow A Discounting Factor B Net PV of cash outflow(A*B)

Year 0 250,000,000.00 1 250,000,000.00

Year 1 52.000,000 0.907 47,164,000.00

Year 2 54.080.000 0.8227 44,491,616.00

Year 3 56,243,200 0.7462 41,968,675.84

Year 4 58,492,928 0.6768 39,588,013.67

Year 5 60,832,645.12 0.6139 37,345,160.84

Total Outflow( Sum of (A*B) year 0 to year 5 460,557,466.35

Figure 2 displaying calculation of discounted cash inflow

Inflow A Discounting Factor B Net PV of cash Inflow(A*B)

Year 1 80184000 0.907 72,726,888.00

Year 2 131827200 0.8227 108,454,237.44

Year 3 82159680 0.7462 61,307,553.22

Year 4 44478919.68 0.6768 30,103,332.84

Year 5 28645720.68 0.6139 17,585,607.92

Total Discounted Inflow (A*B) year 1 to year 5 290,177,619.42

NPV outflow= PV(C0) + PV(C1) + PV(C2) + PV(C3) + PV(C4)+ PV(C5)

=460,557,466.35

NPV inflow= PV (C1) + PV(C2) + PV(C3) + PV(C4)+ PV(C5)

=290,177,619.42

= NPV Inflow NPV Outflow

= 290,177,619.42 - 460,557,466.35

= - 170,379,846.93

From the above calculation, it is evident that undertaking the project would lead to a negative net present value of cash flow. The calculation reveals that the net present value of cash outflow surpasses the net present value of cash inflow, expressed as 460,557,466.35 > 290,177,619.42. This implies undertaking the project would yield a negative value of 170,379,846.93. Hence the firm should not invest in the production of TMax.

Additional Factors to Consider in Project Appraisal

Beyond factoring time value of money, one should pay attention to qualitative factors likely to affect the outcome of a capital investment decision. The investment manager should consider the company culture, environmental implications, safety, ethics and effect to existing investment portfolio. Firstly, evaluation of capital investments likely affects how individuals handle their daily tasks by demanding change in reporting relationships and team dynamic. One should evaluate the impact to the company culture regarding how individuals work together, morale, motivations to excel, things valued by staff and overall physical productivity resources (Miller-Nobles, et al., 2017).

Appraisal of investments obligates the effect on the overall capacity to produce and deliver quality products and services. It is critical to avoid cannibalization of its production capacity. Besides, it is prudent to ascertain the impact on the environment when determining investments one should commit resources (Lawrence & Kleinman, 2012). It makes the case to weigh between appealing options and costly options, hence need to strike a balance between affordability and environmentalism. Lastly, investment proposals require the management to evaluate the ethical issues including employee safety, local employment and public concern besides financial benefits.

Incorporating Risk in Business Investment Decision-making Process

The risk remains a critical component in every investment that one should analyze during capital budgeting decisions. It implies that a meaningful evaluation of investments requires one to determine how much risk present and capable of altering the cash flows amount and timing (Asci, et al., 2014). Execution of investments mandates one to systematically evaluate and analyze risks involved since capital decisions are difficult to revoke (Avram, 2009). The situation makes it appropriate to apply certainty equivalent approach to adjust the risk evaluated before executing the investment. The conversion supports the inclusion of studying to identify and understand investment processes is mandatory to avoid committing the scarce organizational resources.

The inclusion of risk factors during investment appraisal process acknowledges that the future remains uncertain, hence erroneous to assume favorable days in future. Risk involves the variability experienced in expected returns realized as the adverse subset of outcomes for undertaking particular action or exposure to certain conditions. Risk has multi-faceted existence derived from casual factors that one can neither measure nor control precisely (Gilboa, 2010). Its existence may arise from limited ability to process information appropriately. According to Virlics (2013), such a scenario would arise if the investor is unable to process adequate information regarding payoff from all available strategies. It explains why risky events are common in investment context where the information is not available. A risk exists from the high cost associated with obtaining and processing information. However, Peterson (2009) observed that one could not neglect risk and uncertainty while executing investments. Instead, one should match the investments dynamism through proactive follow-on that would allow one optimize the investment value. It demands flexibility during appraisal and follow-on executions since mathematical formulas are barely enough to estimate the returns.

The focus on incorporating risk in investment decisions seeks beyond forecasts that use a single probable prediction. A clearer picture of the investment viability would be possible if one would visualize the variability of returns relative to exposure to risks. The approach would involve the assessment of relative risk and probable odds by simulating how the context would unfold in future. Secondly, the approach would incorporate risk by simulating estimated values of the factors within distributed likelihood of occurrence. It would necessitate conducting sensitivity analysis through identification of factors capable of influencing the context. Project cash flows found sensitive to the listed factors are adjusted for certainty equivalent. However, generating more accurate estimates would require conducting Monte Carlo simulation to portray the uncertainties and risks in the investment context. The computer-based simulation should accommodate a range of various input factors extended from the conventional capital budgeting appraisal decisions.

Incorporating risk during investment appraisal is critical to avoid situations the organizations would incur losses. Their inclusion provides the organization with the opportunity to consider multifactor challenges likely to delay the project, lengthen the payback period, increase the incremental cost and erode profitability in existing portfolio. The inclusion of risks involves embracing sensitivity analysis, Monte Carlo simulation, and determination of certainty equivalent. It is necessary to perform continuous monitoring and testing through adapting enablers technology that ensures full business risk alignment

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References

Asci, S., VanSickle, J. J., & Cantliffe, D. J. (2014). Risk in Investment Decision Making and Greenhouse Tomato Production Expansion in Florida. International Food and Agribusiness Management Review, 17(4), 1-26.

Avram, E. L. (2009). Investment decision and its appraisal. 20(1), 1905-1906.

Gilboa, I. (2010). Rational choice. In Chapter Expected utility (pp. 35-48). The MIT Press Massachusetts Institute of Technology.

Lawrence, K., & Kleinman, G. (2012). Applications of Management Science. Bingley: Emerald Group Publishing.

Miller-Nobles, T. L., Mattison, . L., & Matsumura, . M. (2017). Horngren's Financial & Managerial Accounting. New York: Pearson.

Peterson, M. (2009). An Introduction to Decision Theory. Cambridge: Cambridge University Press.

Virlics, A. (2013). Investment Decision Making and Risk. Procedia Economics and Finance, 6, 169-177.

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Appendix A Explanation

The cost incurred in research and development are disregarded in the calculation of the net present value. They are treated as sunk costs since they were undertaken before the proposal. A similar decision is reached of 10M incurred in developing the smart product alongside the 5m spent in conducting the successful market survey and 6.5M for improving the design features.

The item labeled O in Appendix B for fixed cost is attained by subtracting the annual depreciation cost for the manufacturing equipment calculated as shown in P giving a net value of 24,000,000 being the fixed cost. After that, the general inflation rate of 4% is used to calculate the value of the annual fixed cost figure. A similar treatment is performed at investment labeled V. The calculation of line labeled P is arrived by subtracting the salvage value of 20,000,000 from the initial cost - 200M of the manufacturing equipment before calculating the annual depreciation amount annually using the straight-line method for a five-year lifetime.

Appendix B Calculation of Cash flows

Year 0 year 1 year 2 year 3 year 4 year 5

A percentage of apportionment Sales Volume) 15% 30% 25% 20% 10%

B Production units (A*720000) 108,000 216,000 180,000 144,000 72,000

C Selling Price per Unit (Reduce at 10% p.a) 2,000.00 1,800.00 1,620.00 1,458.00 1,312.20

D Sales Revenue ( Selling Price per Unit *Produced Units) 216,000,000.00 388,800,000 291,600,000 209,952,000 94,478,400

E Production Costs

F sitax units (Ikg per Tmax Unit hence equal to Tmax units produced Annually) 108,000 216,000 180,000 144,000 72,000

G Cost @ 400 Per Unit increasing at 6% per year= 400(1+0.06)n 400 424.00 449.44 476.41 504.99

H Total Cost for Sitax Units 43,200,000 91,584,000 80,899,200 68,602,522 36,359,336

I Zilon units (2kg per Tmax Unit hence equal to Tmax units produced Annually) 216,000 432,000 360,000 288,000 144,000

J Cost @ 110 Per Unit 110 110 110 110 110

K Total Cost for Sitax Units (= Zilon Units * 110) 23,760,000.00 47,520,000.00 39,600,000 31,680,000.00 15,840,000

L Total cost production materials (H+K) 66,960,000 139,104,000 120,499,200 100,282,521.6 52,199,336.45

M labor force (Special Trained) 3,000,000

N variable labor force cost (TMAx units*8 * Hourly rate @ 30) 25,920,000 51,840,000 43,200,000 34,560,000 17,280,000

O Fixed cost (Increasing with inflation rate @ 4% from year 2 = 24000000(1.04) 24,000,000 24,960,000 25,958,400 26,996,736 28,076,605

P Depreciation(200000000-20000000)/5 36,000,000 36,000,000 36,000,000 36,000,000 36,000,000

Q Income Tax before Tax(D-(L+N+O+P) 63,120,000 136,896,000 65,942,400 12,112,742.40 (39,077,541.89)

R Taxes at 30%(0.3*Q) 18,936,000 41,068,800 19,782,720 3,633,822.72 (11,723,262.57)

S Net Income (Q-R) 44,184,000 95,827,200 46,159,6800 8,478,919.68 (27,354,279.32)

T Net Cashflow from Operations (S+P) 80,184,000 131,827,200 82,159,680 44,478,919.7 8,645,720.7

U Initial Investment 200,000,000

V Change in working capital Investment(increasing at inflation rate = annual Investment *1.04) 50,000,000 52,000,000 54,080,0...

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