This part aims to address the real-word components of net cash flows, initial investment and a suitable discount rate in a NPV model in risk management strategies including risk retention, risk transfer, risk control an risk avoidance. With volatility and uncertainty of future risks, risk management is increasingly important for an enterprise to minimize and control risks associated with property losses, personal losses, financial losses and liability losses (Williams et al, 1998; Harrington and Niehaus, 2004). Different risk management strategies are in place to facilitate risk management programs in enterprises. The given question will be illustrated by an example of risk management associated with production hazard risk in a plant. The scenario is that a plant is invested but with the risks of production hazard. Such risks could lead to losses in property, personnel, financial and liability directly and indirectly. Risk retention, risk transfer, risk control and risk avoidance will be analyzed respectively in such a scenario. The NPV model analysis will be conducted in each type of risk retention, risk transfer, risk control and risk avoidance. Generally, a positive NPV indicates a project worthy of investment. The components of net cash flows, initial investment and discount rate will be discussed with the consideration of corporation tax, tax allowance, grants, maintenance costs, etc.
The basic scenario is a project of building a plant lasting three years with the risk of production hazard. In the basic scenario, the positive cash flows include: revenues generated by building the plant and tax savings in depreciation. The discount rate is 15% taking into account of expected rate of return of the project by investors. The plant is depreciated on a straight line basis for 3 years with zero salvage value. The corporation income tax is assumed as 40%. Negative cash flows include corporate income tax on profit margins. The specific numbers are displayed in the scenario as follows:
1. 1 Risk retention
Risk retention could be financed via a captive insurance company, a risk retention group, a special fund, working capital, pre-arranged loans or ad hoc loans (Williams et al, 1998, p. 25).
The components of cash flows include positive ones and negative ones. The negative cash flows include initiative investment for financing risk retention including self-insurance premium, opportunity costs of funds otherwise that could bring rate of return on capital employed, administration expenses related to risk retention. Positive cash flows include the rate of interests on funds, tangible and intangible gains from avoiding bottlenecks in production process due to the risk financing, though the latter one is hard to estimate.
The initial investment includes self-insurance premium, a special fund in place or costs of other types of risk retention. In the scenario of risk retention in the project of building the plant, the initial investment is assumed as 4,000 £ of self-insurance premium. The discount rate reflects the expected rate of return of the investors. In this scenario, it is assumed as 15%.
1.2 Risk transfer
Risk transfer occurs between two parties with one transferring the risks, responsibility for risks or causes of risks to another by paying insurance premium (Williams et al, 1998, p. 25).
The components of negative cash flows include insurance premiums, opportunity losses on the same amount of capital employed on other investments. Positive cash flows include tax savings in premiums and other gains.
Initial investment includes insurance premiums. In the scenario of risk retention in the project of building the plant, the initial investment is assumed as 5,000 £ of self-insurance premium.
Discount rate reflects the expected rate of return of the investors. In this scenario, it is assumed as 15%.
1.3 Risk control
Risk control refers to measures taken to reduce or minimize the frequency or severity of losses (Williams et al, 1998). It involves loss prevention which aims to reduce the frequency of losses and loss reduction which focus on decreasing the severity of losses (Williams et al, 1998, p. 53). Investment in equipment, training, materials required for risk control will incur additional costs but also bring more intangible benefits as well as tangible benefits such as reduced losses, improved labor relations and improved corporate image. In the scenario of the project of building a plant with risk control of production hazard, safety equipment could be installed to reduce the frequency of losses in the form of loss prevention.
The negative cash flows include initial equipment investment, annual maintenance expenses, opportunity costs due to disruption of normal production caused by equipment installment and trial. The positive cash flows include tax savings due to equipment depreciation, grants, and insurance premium reductions.
The initial investment includes safety equipment expenditure and other types of risk control expenditure. In the scenario, the safety equipment expenditure is assumed as 18,000 £. It will be depreciated on the straight line basis for 3 years with zero salvage value. The discount rate reflects the expected rate of return of the investors. In this scenario, it is assumed as 15%.
1.4 Risk avoidance
Risk avoidance refers to refusing to accept a new risk or abandoning an old one (Williams et al, 1998, p. 24). For instance, if the costs associated with retaining risks of a production line outweigh the potential benefits, the production line could be avoided to enter into or if it already exists, it could be eliminated. The equipment could also be leased. It is reasonable only when the opportunity costs in risk avoidance could be outweighed by the benefits of risk avoidance (Baldoni, 2004; Brookfield, 1995).
The negative cash flows in the case of risk avoidance are the opportunity costs if the risk is retained, including the additional revenues, tax savings in depreciation. The positive cash flows in a new project would be the savings of not entering into the project and in an old project; they are the gains from selling an old project.
There is no initial investment in the case of risk avoidance.
The discount rate reflects the opportunity costs if the risk is retained. In the above scenario, it is assumed as 15%.
b）Provide practical suggestions for estimating realistic values for the variables identified in part a) of the question.
The variables in the part a) are the four types of risk management: risk retention, risk transfer, risk control and risk avoidance. The suggestions for evaluating the realistic value of each type will be presented later.
Different projects required different initial investments, net cash flows and discount rate associated with proper risks of the projects. In a given project, based on the benefits and losses of the project, the initial investment and time period is settled once for all.
Therefore, the biggest variables in the NPV model are cash flows and a suitable discount rate, which will be analyzed in this part. Cash flows are analyzed using Brealey-Myers adjusted present value method (1996). It takes into account the tax shields and costs of issuing securities to finance the project (Williams et al, 1998, p. 336). A suitable discount rate of a given project mainly depends on the beta of the project. Therefore, the evaluation and selection of a suitable beta is most important for evaluating realist value for the discount rate of the project.
Suggestions for Risk Control
in a risk-control project in the above scenario of installing a safety equipment, the costs of issuing securities to finance the project should be added to the negative cash flows of the project; the interest payment on related loan should calculated as after-tax adding to the negative cash flows of the project; the indirect costs of disruption of normal production should be also regarded as negative cash flows while costs tax savings on the depreciation of the equipment and indirect benefits such as insurance premium reductions should be added to the positive cash flows of the project.
In short, as to suggestions for risk control project, it is important to take into account:
- the costs of issuing securities to finance the project if there exists such practice
- the interest payment on related loan after tax
- the indirect costs of disruption of normal production
- Tax shield due to tax savings on the depreciation of the equipment
- indirect benefits such as insurance premium reductions
A suitable discount rate
A discount rate reflects the risks associated with the project as well as the expected rate of return of the investors. A suitable discount rate on a project is determined by riskless rate of interest, market risk premium and a suitable beta (Borowka, 1991; Pores, 1995). The riskless rate of interest is the same and out of control of the risk manager. The market risk premium is calculated as follows: the expected rate of return on a market-proportioned portfolio of risky securities reduces the riskless rate of interest (Ashby and Diacon, 1998). The most important factor is to evaluate the realistic value of beta. The increased beta increases the discount rate of the project and decreases the present value of the project, or vice versa (Williams et al, 1998, p. 334).
In order to evaluate the realist value of beta, it is important to evaluate the risk of the particular project rather than the risk of the organization (Crockford, 1976). If the project is associated with the primary line of organizational business, the risk of the project is usually similar to that of the organization. Otherwise the beta should reflect the risk of the particular project. It is reasonable to consider the possibility of negative beta in the case of loss-control project (Williams et al, 1998, p. 335). For instance, the benefits of loss-prevention project increase when the state of economy performs poorly, for the claim costs are highly likely to increase. However, different projects with unique risks require different rate of return and beta to evaluate their realistic value. In short, it is suggested to:
- Consider the characteristics of a particular project and evaluate its unique risks to determine the proper beta
- Consider the possibility of negative beta in the case of loss-control projects
- Determine the proper beta based on all possible considerations of the relationship between the rate of return, cash flows and the state of economy
In summary, NPV model is an effective tool to evaluate the value of an investment project. The risk manager should consider the nature of different risk management strategies in using such model. In order to evaluate the realistic value of the risk management project, net cash flows and a suitable discount rate should be carefully considered, factored in indirect benefits and costs and other potential side effects of the project.
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