THE IMPORTANCE OF RISK MANAGEMENT FOR MAKING LONG - TERM FINANCIAL DECISIONS

Transcription

1 THE IMPORTANCE OF RISK MANAGEMENT FOR MAKING LONG - TERM FINANCIAL DECISIONS Miroslav Gveroski, PhD Faculty of economics-prilep Aneta Risteska Faculty of economics-prilep ABSTRACT The paper consists of four parts. The first part is introduction of the analyzing problem. Second part explains different types of risks whish have a influence in making investment decisions. Third part includes process of risk management and its phases. Fourth part is dedicated to involving responds of risk in investment project evaluation and methodology of some criterions. This part includes importances of these criterions for making quality investment decision. At the end is conclusion made by researching in way to help managers to handle with risk. Key words: risk, risk management, investment decision Introduction Investment decision is complex process whereon foregoes evaluation of investment idea. Realization decisions for certain investments create the future of the company and achievement of its goals. Presiding of investment ventures is a prominent step so the company can exist in competitive surrounding. Through realization of investment projects assets are used in present while projected incomes are expected in the future. Investment project lifecycle is a long-term period. In order to bring decision whether investment project will realize or not, requires analysis exerted with investment criteria assistance. The goal of each entrepreneurial venture is attainment of income (profit), well even in this case investment project will carry out if projected incomes are bigger than costs. After bringing decision for realization of investment process, the influence of multiple risks that can change expected movement of the project in market horizon should be estimated. Therefore the risk management has great significance. 207

2 1. Types of risk which have respond for making investment decisions The main motive of companies is making profit. If they want to successes in their goal they have to intercourse a lot of investment projects. Making investment decisions is a hard process which has influences of different types of risk. The risk can be classified by many aspects. 1. From the aspect of importance of risk for making investment decision, risk can be: financial and non-financial risks [13]: a term risk means opportunity for becoming unexpected alteration where financial lost would crop up, while from other types such loss wouldn t occur. Statistical and dynamic risks; [14, page 14-19] statistical risks refer to all ongoing events that doesn t mean alteration in economy, but still unexpected movement may occur during the implementation of intended goal; while dynamic risks come as a result of certain alteration in economy which in correlation to statistical are more unpredictable, as an example: price variation, consumption variation, income, production and technology and other changes that may provoke creation of unexpected results. 2. From the aspect of risk analysis of investment project as a special unit and from aspect of project as one of multiple accomplished and future projects of a certain company, the risk oversees as individual riskiness to project, riskiness of project for the company, market riskiness of project..[8, s.208] Other division of risk in investment division is to systemic and non-systemic risks. In systemic risk interlace various external effects of success of investment challenge, from where socio-economic and political goings-on can be distinguished as well as the general market movements. While non-systemic risk includes those changes that haven t got prevalent dimension and doesn t influence to each investment, but also should be analyzed for each investment. According to this division following types of risks can be distinguished: credit risk, liquidity risk, capital price list, currency risk, and country risk. [3, p ]. 3. The other types of risk which are important for making investment decision are: [16] Inflation Risk: The risk that the rising costs of inflation will outpace the growth of your investment over time. Company Risk: This is the risk that the individual company in which you invest will fail to perform as expected. Legislative Risk: Whatever laws the government passes today may be extinct tomorrow. For example, the long-term capital gains tax rate has been changed five times in the last 20 years, with the most recent cut at 20%. Factors such as tax deduction and deferral should never be your sole reason for selecting an investment. These perks are at the mercy of Congress. Global Risk: It's always a bigger risk to invest overseas than at home. Then again, it's generally more rewarding to vacation in Europe than lounging around in the backyard. Over 50% of the world's capital market opportunities exist outside of the U.S., so a purely domestic strategy can severely limit your long-term earnings potential. Timing Risk: Timing risk works two ways. First, you run the risk of investing a large sum of money when share prices hit their peak. Second, there's the risk that you'll need to access your money to pay for retirement or college expenses during a temporary market setback--causing you to lose money on your investment. 208

3 2. Risk management Risk management is a central part of organisation s strategies management. This compound process includes: identifying, analysing and handling with risk during the life- cycle of investment project. Risk management should be a continuous and developing process which runs throughout the organisation s strategy and implementation of the strategy. At the beginning it s necessary to define a risk. Risk is possibility of loss, injury, disadvantage or destruction. Risk is a measure of probability and consequence of not achieving project goal. Most people agree that risk involves the notion of uncertainty.[6, p 653 ]. The main goal of risk management is maximizing incomes and minimizing the potential risk in the project. Risk management includes several related actions involving risk: planning, assessment (identification and analysis), handling and monitoring. Risk planning is the process of developing interactive strategy and methods for identifying and analyzing risk issues, developing plans for handling with risk and monitoring how risk have changed. The important output of risk planning is the risk management plan. At the begging of the project, project team maintain a meeting with one important goal to develop plan for risk management. The risk plan management process (RMP) is the risk related roadmap that tells the project team how to get from where the program is today to where the program manager wants it to be in the future. The key to writing a good RMP is to provide the necessary information so the program team knows the objectives, goals, and techniques of the risk management process: reporting, documentation and communication; organizational roles and responsibilities; and behavioural climate for achieving effective risk management. Since it is a roadmap, it may be specific in some areas, such as the assignment of responsibilities for project personnel and definitions, and general in other areas to allow users to choose the most efficient way to proceed [6, p 663 ]. Another aspect of risk planning is providing risk management training to project personnel. The training can be performing by individuals, whether inside or outside the project with experience in making risk management work on project. The phase of risk assessment includes identification and analyzes of risk. The result of this phase is a key input to many subsequent risk management actions. This phase is very difficult and time consuming part of the risk management process. Risk assessment has a large impact on project outcomes. The goal of risk identification is to identify all potential risk issues. The important techniques for assessing the risk are: Brainstorming is a technique which is used for finding solutions for the problems which has happened spontaneously. A Delphi technique is an interactive procedure which is based of known and unknown inputs which are connected with actions in the future. The data are collected by experts, and they give hypothesis about future development. The interview is a technique for collecting data in direct speech with employ or managers. SWOT analysis is a technique that undertakes into account strengths, weaknesses, oportunties and threats, adjacent to playing great role in strategic planning it is also used for identification of potential risks of the particular project. A lot of techniques and methods are used during the risk analyzing. For example, tree decision and simulation whish are used for quantitative analyze. After the identification risk can be ranges as: 209

4 High risk : substantial impact on cost, schedule or technical; Medium risk : some impact on cost, schedule or technical; Low risk: minimal impact on cost, schedule or technical These terms for rating the risk are relative terms. A risk viewed as easily manageable by some managers may be considered hard to manage by less experienced or less knowledgeable managers. Risk handling includes methods and techniques to deal with known risk, identifies who is responsible for the risk issue, and provides and estimate of the cost and schedule associated with reducing the risk, if any. The evaluators who assess risk should begin by identifying risk and developing options and approaches for handling risk. The options for handling risk fall into the following categories:[6, p 682 ]. - risk assumption is an acknowledgement of the existence of a particular risk situation and a conscious decision to accept the associated level of risk, without engaging in any special efforts to control it. The key to successful risk assumption is twofold: 1. Identify the recourses that will be needed to overcome a risk if it materializes. This includes identifying the specific management actions that may occur. 2. Ensure that necessary administrative actions are taken to identify a management to accomplish those management actions. - risk avoidance involves a change in the concept, requirements, specifications and practice to reduce risk to an acceptable level. It eliminates the sources of high or medium risk and replaces them with a lower risk solution. - risk control does not attempt to eliminate the sources of the risk but seeks to reduce the risk. This option may add to the cost of a program, and the selected approach should provide an optimal mix among the candidate approaches of risk reduction, cost effectiveness and schedule impact. - risk transfer may reallocate risk from one part of the system to another, thereby reducing the overall system and/ or lower level risk. The phase risk handling has cost implications. The mangers should choose specific approaches which means minimizing the cost. Risk monitoring The goal of risk monitoring is providing and developing risk handling strategies or reanalyzing known risks. In some cases monitoring results may also be used to identify new risks and revise some aspects of risk planning. Risk monitoring as proactive methods helps in reducing risks to acceptable levels. As any other monitoring and review process as risk monitoring should determinate wheather:[15] the measures adopted resulted in what was intended, the procedure adopted and information gathered for undertaking the assessment were appropriate, improved knowledge would have helped to reach better decisions and identify what lessons could be learned for future assessments and management of risks. 3. Investment decisions in terms of risk The larger complexity, versatility and improvidence of relevant factors that enable development and endurance of the company, impose the need of sufficient risk management throughout investment decision. Therefore it is necessary to choose adequate techniques with a goal for adjustment of investment decisions to changes as a result of risk existence. In this part of 210

5 the paper three techniques will be exposed: net current value, internal profitability rate and return period. One of the most commonly used adoption techniques for adjustment of the process of investment decision and projected dimensions of risk influence is net current value. Utilization of this procedure can be performed twofold: accommodation of discount rate or calculation of equivalence ratio. Within net current value criteria, if current value of the projected cash flow is bigger than current value of project cost, investment is estimated as acceptable, and opposite, if current value of projected cash flow is smaller than current value of the project cost, investment is estimated as unjustified. While amongst internal profitability rate if project incomes are bigger than capital costs it would mean that within realization of the project it will increase investor s welfare. Economic feature of these criteria rely on calculation of discount rate and economic aspects fixed in its level and influence on investment s decision. The process of determination of level rate with which cash flows will be discounted it s not simple because of among its size influence multiple factors, where most important are: - Varieties and separately participation of financial sources in financial construction of the project; - Condition at domestic capital market; - Condition as international capital market; - Economic condition of domestic economy (situation in national economy) - Economic-financial condition of the company itself; - Variety and risk ration in investment.[7] This means during that process discount rate has to be adjusted of percept level of risk, with an objective in consistence of bringing investment decision because the risk is estimated. Discount rate adjustment is pursued through embedding of so-called risk premium. The new discount rate will present summary of non-risk discount rate and estimated value of risk premium. With that discount rate will become higher for the risk premium. The question propounds, how much premium estimate should be: two, four, ten or more percents. The risk premium range has to consist: compensation for expected inflation, extra income for uncertainty of future incomes and market risk premium. Investors at the time of decision of investment project have more alternative projects with various risk level. Risk variances also mean supplementing of various risk premiums of discount rate. Those projects with highest risk would be discounted with highest discount rate because of the highest risk premium. In the usage of discount rate with added risk premium when current value of cash flow is estimated, it will contribute to smaller amount of cash flow from projected value, and then the investor may overview the project validation. On this way the investor is more sure in the choice whether to invest or not. The substance in usage of discount rate is that in monetary value of projected cash incomes and outcomes is transferred into current value. Throughout the choice of discount rate has to take into account to build-in (include) following: to represent average value of used capital sources for project financing pond rated ponderated for the level of their contribution, it s calculation to be adjusted on the tax level of cash flow, need to build in inflation rate if previously not included into projected cash flow, the rate being adjusted to the level of systemic risk and need to consider certain corrections of the level of interest account because of adjustable risk dimension. [4] 211

6 Another technique that can be used for adjustment of investment projection of possible investment risks is direct adjustment of risk cash flow. That is realized on a way that once evaluated cash flows are converted in non-risk by usage of safety equivalence. Used safety equivalence is obtained by dividing of risk and non-risk cash flow. Based on that that calculation of discount rate is subjective and safety equivalence itself it s not exempted from that negativity. Based on that the choice of investor will depend on that whether he prefers high risk or not. Usually, it is considered that cash flows referred to long term, in the future are more risky than those relate to close future. This doesn t has to be correct, so more common it is happening investment projects with incomes in near future being more risky. That usually refers to projects that mean introduction of new product on the market or approach to new market and similar. Another procedure for involvement of the risk thru investment decision is return period criteria. This criterion enables to determine the return period if invested capital. Investor would decide for project with short-term return of invested capital, because on short-run would quote return of invested capital. Conclusion The main goal of this paper is to get accomplishments about investment process and making financial decisions in terms of risk. There are a lot of types of risk which have influence in making decisions. Therefore the risk management is very important and risk management sholud be a central part of organisation s strategies management. This compound process has to include: identifying, analysing and handling with risk during the life-cycle of investment project. Risk management should be a continuous and developing process. A probable investor should know about all types of risk during the making investment decisions and how to manage with them. The probable investors should not call off idea to invest just for subsisting the risks but the opposite, they should accept the investment projects, they should handle with risk and on that way to realize incomes. And there are investment decisions adoption techniques of risk efficacy, which helps to investors for making investment decisions. References: 1. Axelsson Helen, Jakovicka Lulija i Khedache Mimmi, Capital Budgeting Sophistication and Performance A Puzzling Relationship), Graduate Business School, School of Economics and Comercial Law, Goteborg University; 2. Block B, Stanley & Hirt A. Geoffrey, (2002), Fondation of Financial Management, McGrow Hill Irwin, tenth edition; 3. Cvetkovič Nataša, (2002), Strategija investicija preduzeča, Institut Ekonomskih nauka, Beograd; 4. Đuričin Dragan, (2003), Upravljanj e(pomoči) projekata, vtoro izdanje, Ekonomski fakultet, Beograd; 5. Fiti Taki, Vasileva Hađi Markovska Verica, Bejtmen Milford (2007), Pretpriemništvo,vtoro izdanie, Ekonomski fakultet, Skopje; 6. Harold Kerzner, Project management - a system approach to planning, scheduling And controlling, John Wiley & Sons, New Jersey, 2003 (eight edition), 7. Nestorovski Metodija, (2000), Ekonomija na investiciite, Ekonomski fakultet, Skopje; 212

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