Risk Analysis On Investment Decision

Risk Analysis on Investment Decision

Net present value, internal rate of return, and profitability index are measures used to compare two mutually exclusive capital investment proposals. "SAI wants to increase market share and keep up with technology, which can be done by either expanding their existing Digital Imaging market share or by entering the Wireless Communication market," (UoP, 2007). Both alternatives have areas of opportunity as well as potential risks that the company will have to consider. This paper will analyze the investment risk decisions SAI currently faces with the objectives of increasing its market share and keeping pace with technology.

An analysis reveals that an expansion into the wireless communication market may be beneficial to SAI. SAI's specialized chip, used in data enabled mobile phones, has performed well in pilot tests, (UoP, 2007). A number of risks, internal and external, are inherent in joining this industry. Similarly, a number of strategies are available to mitigate these risks.

One risk associated with the decision to enter into wireless communications is that of market risk. Market risk is made up of the uncertainties of changes to market prices or rates. While this type or risk is a little harder to foresee than others, SAI can lessen its risk. Diversification is a logical way to reduce market risk. Diversification is an investment technique that mixes a wide variety of investments within a single portfolio, (Investopedia, 2007). It asserts that a portfolio of different kinds of investments will on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Market risk is further subdivided into systematic and unsystematic risk. "Systematic risk is any risk that affects a larger number of assets, each to a greater or larger degree," (Ross, et al., 2005, p. 275). Unsystematic risk is the risk that specifically affects a single asset or small group of assets. While preparation and forecasting helps reduce the level of risk for each, a well diversified portfolio will most likely be the most optimal way to reduce risk.

The cost of capital is another risk posed by investment strategies. Cost of capital is the rate of return that a business could earn if it chose another investment with equivalent risk, (Cost of Capital, 2006). By deciding to enter the wireless communication market would mean an 18% cost of capital, (UoP, 2007). SAI can mitigate this risk through liquidity enhancements. This is accomplished by obtaining more uninformed investors through stock splits which makes round lots more affordable so that small businesses and uninformed investors are more apt to purchase the company's stock. SAI can also enhance liquidity and reduce cost of capital by offering its stocks online. Online direct stock purchases and dividends reinvestment programs allow companies to disclose more information and sell stocks at much cheaper rates narrowing the gap between the informed and uniformed investors.

Yet another risk presented by investment strategies is asset/liability matching. This financial risk occurs when the interest rate (cost) of source funds changes while the interest rate on the uses of those funds (benefit) remains constant, (Plesko, 2007). If SAI invests in the wireless communications market now only to have its credit line interest rates steadily to climb before the expected seven year life of this project is complete, then from a financial prospective this investment will no longer be attractive. The risk of interest rate volatility typically can be controlled through asset/liability matching, (Plesko, 2007). Since the expected life for this investment is seven years, SAI will also want its source of funds to be fixed for seven years. Here, taking a seven year fixed loan would be better than using a line of credit. "Locking in the source of funds eliminates the risk that the interest rate will change during the period for which the funds are to be used," (Plesko, 2007, para. 2).

Capital risk, currency risk, and liquidity risk also pose challenges for SAI. Capital risk results directly from money that the company invests. If assets are invested in another currency, fluctuations in currency value create currency risk. Assets that are not easily sold because the market is small and takes a long time to sell create