Risk Anaylsis

Risk Analysis on Investment Decision

University of Phoenix

MBA 540

In the capital budgeting simulation, several risk associated with Silicon Arts Incorporated (SAI) were presented. SAI is a digital imaging company who manufactures digital imaging integrated Circuits (IC's) that are used in digital cameras, DVD players, computers, and medical and scientific instruments. The company's goal is to increase their share of the market while staying in tune with technology. SAI has proposed two options to accomplish this, expand the current digital imaging market share and implement interested into wireless communication market. The review of the cash flow projections show opportunity costs, NPV, and IRR for each option. These reviews show a more practical investment choice is for SAI to enter the wireless communication market. The internal and external valuation techniques will be used to discuss risks associated with the proposed investment resolution to accept or further develop a particular project.

Several risks were presented in the stimulation. The sensitivity analysis approach to analyze the impact of risk on capital budgets was discussed. "The sensitivity analysis approach is rudimentary and is primarily useful in drawing the analyst's attention to the most important sources of risk to the project" (Sick, 2006, pg. 11). For example, the simulation evaluated a simple sensitivity analysis of NPV changes as a result of changes in cost of capital, cash flow, sales projections, etc. "The sensitivity analysis is one approach (a.k.a. what-if analysis and bop analysis1), which examines how sensitive a particular Net Present Value (NPV) calculation is to changes in underlying assumptions" (Ross 2005 p169). This tool helps to also identify the probability of the projects possibility of a negative value. Thus, "sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions" (Jaffee, Ross, & Westerfield, 2006, pg. 10). "Another approach is the break-even analysis. As its name implies, this approach determines the sales needed to break even. The approach is a useful complement to sensitivity analysis, because it also sheds light on the severity of incorrect forecasts. We calculate the break-even point in terms of both accounting profit and present value" (Ross 2005 p 216).

If the ultimate goal is to maximize shareholder wealth, any project with a positive NPV that cannot be delayed or can be undone should be followed. Capital project investment decisions are often made by comparing and contrasting the economic impact of project profit to economic value of its costs. The dissimilarity between the two is called NPV. In the simulation, the proposed solution to enter a wireless communication market yields a higher NPV than expanding the digital imaging market. "In this latter ,case of mutually exclusive projects, the NPV decision criterion is to maximize the value of the firm by accepting the project with the highest NPV, provided the NPV is positive" ( Sick, 2006, pg. 3). According to Sick, "IRR is an unreliable way of ranking mutually exclusive projects. Its rankings may conflict with NPV, in which case the NPV rankings are preferred, because they measure increments to wealth (2006, pg. 5). As a result, the decision to accept the wireless communication proposal was accepted, but not based on the IRR because this valuation tool is not has reliable as NPV. In order to ensure a successful investment, it is important to evaluate the different types of risks involved.

Long-term growth and success is the goal of shareholders and investors. Although immediate profits, cash flow are also acceptable, longevity is more important. "In capital budgeting, the profitability index measures the bang (the dollar return) for the buck invested. Hence, it is useful for capital rationing" (Ross 2005 p166). Thus the wireless market is the best capital budgeting decision for SAI.

The investment in net working capital is an important part of any capital budgeting analysis.

In order to complete an analysis the Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI) will be calculated. The difference between the project's value and cost is the NPV. "IRR always reaches the same decision as NPV in the normal case where the initial outflows of an independent investment project are only followed by a series of inflows" (Ross 2005 p168). In order to come to the final NPV, IRR and PI the cashflow statements will be analyzed. This will be accomplished by examining the assumptions made while predicting sales, price and marketing costs for the proposals. Checking with the capital expenditure schedules planned is optimal and accounting for hidden cashflows. Finally, accommodating for the risks inherent in the proposals and leveling the cashflow streams of the two proposals using Annuity calculation are imperative. Once all the steps are completed the proposal with the highest NPV, IRR and PI values should be chosen.

A recent worldwide study has forecasted that the Digital Imaging semiconductor market will grow 20% in Year One. The demand will grow seven percent annually from Year Two onwards. By Year Five, new technologies will take over the market. SAI plans to generate $54 million in Year One form the sale of about 400,000 units. The life of the project would be five years. Entry barriers are intense competition and price war, prices to go down five percent annually in year two and three and in years four and five prices are expected to fall as well. Marketing costs to go up to five percent of sales in years one, two and three as chip manufactures need to develop a