Question

Discuss the different types of financial and non-financial risks which pertain to your organization (you can also consider any company ). Consider your organisation or the company related to your group industry project, recommend a capital investment project and discuss what value will it add to the firm and should the organisation take up the project or not? (Hint: Use capital budgeting).

Answer 1

Financial risk

The financial risk of a company can be segregated into two parts

Systematic and Unsystematic

Systematic

It is often called as external risks caused due to the presence of macro factors in the market. This types of risk cannot be washed out by applying diversification

Examples of such risks are interest risk, market risk, purchasing power risk etc.

Interest risk

In case of long term investment particularly in the field of debt investment this kind of risk is found. The interest rate can be changed frequently so to invest one’s fund for the long term basis can the risk like interest rate risk

Market risk

It is caused do to the variation of return found in the stock market due to the presence of volatility in the market that causes upward movement of the stock prices and its downward movement.

Purchasing power risk

It is likely to happen to the return of the investors caused by inflation. The presence of inflation decreases the purchasing power of the currency.

Unsystematic risk

Unsystematic risk also known as internal risk can be minimised by of diversification. Anyhow, this type of risk occurs internally e.g. Raw material problem, labour problem, management problem etc. These are the micro factors which cause internal risk of the firm

If the operating environment of the firm causes any risk such risk is termed as business risk and when the wrong adaptation of financial policy causes financial problem in the firm such types of risk is called financial risk.

Non financial risk

There are different types of non financial risks found in a firm. These are:

1) Supply chain risk

Demand risk: In relation with supply chain function this types of risk occur when unpredictable demand takes place for the product or when the demand of the customers are wrongly judged by the management

Supply risk: When the flow of raw material is interrupted which leads to hamper the production and the flow of sale of the firm.

Environmental risk: It is likely to happen due to the varied factors in the economic, social, governmental activities.

Business risk: If the stability of the management gets affected it creates threat to the firm. The varied stability can be occurred due to disruptions found in the internal system in a firm, wrong assessment in planning and its execution and lack of control over the employees. When a management is restrained to choose the right alternative during the time of emergency and to pass on negative information relating to any unexpected incident of an organization.

2) Quality control risk

This is another types of non financial risk which occurs when a firm undergoes poor quality management policy as to become economically relevant in the market a firm should grow in size and in this connection the firm should adopt satisfactory quality management system which is based on eight factors

• Customer focus
• Good leadership
• People engagement
• Proper system approach
• Always in the mode of improvement
• Facts related decision making
• To develop values to the organization and its peers

3) Operational Risk

This kind of non financial risk may occur due to human error. The error can be happened due to lack of decision taking capabilities which arises not to judge the priority of the situation relating to production and to ascertain the overall cost of the functions of different departments of the firm. For example if the management chooses the wrong raw material for its low cost price by rejecting better quality raw material it will disdain the quality of the product which decreases the demand of the product in the future.

4) Regulatory Risk

When there is any change takes place in regulation this kind of risk is formed. It not affect the company but also the industry under which the company is functioning. The change in regulation may increase the operation costs, introduce administrative problems or create such situation for which a firm may stop its business.

Second part of the question

A company called ‘Cosmos’ is a manufacturing company produces electronic products. Now it requires to consider the two projects and to choose the better one therefore, the project is mutually exclusive. Cost per project is $120

The cash flow from Project A is Y1-$25, Y-2$35,Y-3$45,Y-4$65,Y-5$65,Y-6$55,Y-7$35,Y-8$15

Project B Y1-$40, Y-2$60,Y-3$80,Y-4$50,Y-5$30,Y-6$20

A’s life is 8 years and B’s life is 6 years. There is no salvage value at the end of the project. Tax rate is 50%. The cost of capital is 15%

Which project to choose?

Project A (Currency in $)
Year	Cash flow	Depreciation	EBT	TAX	PAT	NET CF	Cost of capital(15%)	P.V.
1	25	15	10	5	5	20	0.87	17.40
2	35	15	20	10	10	25	0.756	18.90
3	45	15	30	15	15	30	0.658	19.74
4	65	15	50	25	25	40	0.572	22.88
5	65	15	50	25	25	40	0.497	19.88
6	55	15	40	20	20	35	0.432	15.12
7	35	15	20	10	10	25	0.376	9.40
8	15	15	0	0	0	15	0.327	4.91
						PV of Cash inflows		128.23
					Less: Cost of the project			120.00
					Net present value			8.23
Project B (Currency in $)
Year	Cash flow	Depreciation	EBT	TAX	PAT	NET CF	Cost of capital(15%)	P.V.
1	40	20	20	10	10	30	0.87	26.10
2	60	20	40	20	20	40	0.756	30.24
3	80	20	60	30	30	50	0.658	32.90
4	50	20	30	15	15	35	0.572	20.02
5	30	20	10	5	5	25	0.497	12.43
6	20	20	0	0	0	20	0.432	8.64
						PV of Cash inflows		130.33
					Less: Cost of the project			120.00
					Net present value			10.33

Since the Net present value of Project B is higher therefore, this project should be chosen.

Since by taking project B it will increase the profitability of the firm and enhance the shareholders’ value it is worth pursuing for the shareholders of the firm. Since the nature of the investment for the long term period therefore, clarity about the cash flows is most important factor for the firm and its shareholders that has to be calculated in the light of discounting factor known as cost of capital of the firm although inflation is major factor to evaluate the strength of the money as if the inflation changes during the period the clarity of the cash flow amount can be changed so the value of the firm and it may put lots of impact into the wealth creation of the shareholders. Therefore projection of return to calculated strongly otherwise the owner of the firm or called the shareholder of the firm cannot achieve the desired value.