Case Scenario:
The riskiness of an investment project is defined as the variability of its cash flows. While evaluating the level of risk, the Chief Financial Officer (CFO) of an organization should assume that the present value of cash is greater than the company's future value. The level of risk is directly proportional to possible profitability. "An organization who is actively seeking investment opportunities for the sole purpose of maximizing growth and shareholder wealth must utilize three approaches to analyze the valuation of the potential investment alternative. The three valuation approaches an organization should incorporate while making investment decisions include; the costs asset approach, the income approach, and the market approach (Kovaliov et al, 2006). The cost asset approach values a company by accumulating the cost that would currently be required to replace the asset. The premise of the cost approach is that an investor would pay no more to purchase the asset than would be paid to reproduce the asset. The income approach considers future earnings by calculating the present value of projected cash flows at a reasonable present value discount rate. There are two kinds of methods associated with the income approach such as; methods of single period-dividend capitalization, earnings capitalization, cash flow capitalization, and methods of multiple periods- that consists of analyzing discounted cash flows. The market approach values a company based on comparison with sales of similar companies. The following valuation methods are used; comparable transactions, comparable asset distinguishes by similar market value; calculation of market multipliers, capitalization of market value, per one unit of resources or capitalization of market value per one unit of yearly production. These indicators are calculated by dividing the whole amount of capital from the sum of resources of yearly production volume" (Kovaliov et al, 2006)
Risks:
All investments are subject to one or more types of inherent risk. It is expected and necessary to assume some level of risk in order to achieve needed returns. The initial step in analyzing potential risk issues it to develop a checklist. The initial step in formulating a mitigation plan for potential risk issues is to first identify the types of risks that are associated with each investment decision:
1. Capital Risks-the risk of losing the original investment
2. Credit Risk-the risk that the issuer will not make scheduled payments.
3. Liquidity Risks-The risk that the investment cannot be readily converted to cash at prevailing or assumed prices.
4. Operational Risk- The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This includes legal risks, but excludes strategic and reputational risks.
The next step may be to convene a team of stakeholders, investment and program analysts, union representatives, and other interested colleagues. A team comprised of a broad functional-set helps to formulate an objective assessment. The team reviews the material and arrives at a consensus of each facet's rating for each investment alternative by double blind voting (independent votes not visible to others) and justification discussions. The team also affirms or complements issue mitigations. At the end of these discussions, the least-risk alternatives investment decision emerges. The analyst then coordinates with the cost, benefit, and other analyst to link the impact of the risks and their mitigation on the cost and/or the benefit estimate of the recommended investment alternative. The products of the mitigation efforts may result in a stand-alone summary section within an investment analysis report, solid input for creating cost and benefit high-confidence ranges around the most likely numbers, direct input into the organizational risk assessment.
"The risk management approach to investment opportunities requires identification of vulnerabilities and threats that are most likely to occur, quantification of the potential harm to the organization opting to invest or acquire new organizations, and development of mitigation efforts to re-establish an acceptable risk management policy. The mitigation process begins with the implementation of a strident risk management narrative including a statement of the company's acceptable risk tolerance used to determine policies and acquire new assets. The risk identification process utilizes extensive research to identify prospective vulnerabilities and potential threats. Through risk analysis, potential threats are identified and quantified according to the likelihood of anticipated gains not being met." (Akeman, 2001).