Risk Analysis On Investment Decisions

Risk Analysis on Investment Decisions

Investment techniques used in corporate finance when making decisions on projects usually focuses on cash flows of the firm (Ross, Westerfield, and Jaffe, 2004). Because of drastic changes in the business environment over the last decade, managers are requesting better, more accurate information, and improved techniques to meet company needs for making major decisions with data consisting of clear goals, a planned design, high ethics, revealed limitations, adequate analysis, and justified conclusions (Cooper and Schindler, 2003). In this paper, the methods of net present value and internal rate of return are examined based on real-world capital budgeting decisions. This paper also gives insight on valuation techniques used to determine internal and external investment decision strategies and the risk associated with the investment decisions.

In the Capital Budgeting Simulation, Silicon Arts Incorporated (SAI) is a four-year old company that produces digital imaging integrated circuits (IC) used in computers, digital cameras, medical and scientific equipment, and DVD players. The company presents a strong front in North America, generating 70% in sales annually, capturing 20% in sales in Europe, and 10% in sales in South East Asia. SAI's annual sales turnover is $180 million. In the last few years, Silicon Arts IncorporatedÐ''s revenues have decreased by 40% due to industry slowdown which led SAI to freeze capital expenses and reduce capital costs. Kathy Lane, Chief Financial Officer of Silicon Arts Incorporated, requested the post financial analyst to analyze two capital investment proposals set-up by Hal Eichner, chairman if SAI, and determine the best proposal that will increase market share and help the company remain competitive. The company is faced with deciding to expand the existing digital imaging market share or enter into the wireless communication market by determining net present value and internal rate of return.

Internal Investment Strategy Techniques

Companies pay extra cash in dividends to shareholders or the positive cash flow is used to invest in a profitable project. Shareholders expect the company to invest in projects only if the return is larger than the financial risk, with the expected return representing the firm's cost of equity capital. To determine a companies cost of equity capital, we must know the risk free rate, the market-risk premium, and the company beta-the standardized covariability of a stock's return with the market return, which in the real world, must be estimated based on either the firm's beta or the industry beta (Ross, Westerfield, and Jaffe, 2004). The firm's beta is determined by the characteristics of the company- the revenue cycles, operating leverage, and financial advantage. When companies consider projects, the project should be discounted at the corporate rate, but not necessarily at the same discount rate for all projects. Because expected return and cost of capital are negatively related to risk, a firm must increase the liquidity of stock to lower the cost of capital.

External Investment Strategy Techniques

Mergers and acquisitions is a strategy a company can use to generate cash flow. When one company acquires another company, the acquiring firm chooses the legal method, the accounting method, and the tax status. Consolidation, acquisition of stock, and acquisition of assets are the three basic legal procedures that a company can use to attain another (Ross, Westerfield, and Jaffe, 2004). Mergers and acquisitions are taxable or tax-free transactions. Each selling shareholder must pay taxes on the stock's capital appreciation in a taxable transaction, and they do not pay taxes during the period of tax-free acquisition. Mergers and acquisitions accounting involves a choice of the purchase or the pooling-of-interests methods with most financial managers preferring the pooling-of interests method because "net income of the combined firm under this method is higher than it is under the purchase method" (Ross, Westerfield, and Jaffe, 2004, p.823). The choice between the methods does not affect after-tax cash flows of the firms.

"The difference between the value of the combined firm and the sum of the values of the firms as separate entities is the synergy from the acquisition" (Ross, Westerfield, and Jaffe, 2004, p. 802). The acquiring firm generally pays a premium for the acquired firm. One reason for acquisition of another company is that a combined firm generates greater revenues. Increased revenues may come from marketing gains, strategic benefits, and market power. Mergers and acquisitions produce greater operating revenues through improved marketing and the shareholders of the acquiring firm will gain if the synergy from the merger is greater than the premium (Ross, Westerfield, and Jaffe, 2004). Benefits of an acquisition derive from revenue enhancement, cost reduction, lower taxes, and lower cost of capital.

Risks Associated with Investment Decisions

Capital budgeting must be placed on an incremental basis, ignoring sunk costs and considering both opportunity costs and side effects. As the company expands, working capital rises over the early part of the project, with all working capital recovered at the end of the project. All inventories is sold by the end of the project, the cash balance is liquidated, and all accounts receivable are collected, generating cash from other sources in the company, hence cash outflows. If working