Annals of the University “Constantin Brâncuşi” of Tg-Jiu, No. 1/2008, Volume 3,
Editura Academica Brancusi, Tg-Jiu, ISSN: 1842-4856
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.
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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.284-287].
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.
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Annals of the University “Constantin Brâncuşi” of Tg-Jiu, No. 1/2008, Volume 3,
Editura Academica Brancusi, Tg-Jiu, ISSN: 1842-4856
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:
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Annals of the University “Constantin Brâncuşi” of Tg-Jiu, No. 1/2008, Volume 3,
Editura Academica Brancusi, Tg-Jiu, ISSN: 1842-4856
− 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
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Annals of the University “Constantin Brâncuşi” of Tg-Jiu, No. 1/2008, Volume 3,
Editura Academica Brancusi, Tg-Jiu, ISSN: 1842-4856
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]
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Annals of the University “Constantin Brâncuşi” of Tg-Jiu, No. 1/2008, Volume 3,
Editura Academica Brancusi, Tg-Jiu, ISSN: 1842-4856
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.
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