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Financial Risk Assessment

Introduction

Investments are taken as risks. Investors invest their money into a business expecting returns, however, the investment may make profits or losses. financial risks are any possibilities of a shareholder or investment will lose money from an investment. As a matter of fact, financial risks are inevitable. However, investors are required to conduct a thorough analysis of possible risks before investing. Some business risks include losses, low sales, credit or borrowing risks or competition that results in low investment returns or negative incomes. Knowing the expected risk does not eliminate the risk, however, it helps in mitigating the harm it may come with. The volatility of the business world brings the uncertainty of market assets of the fair value. As part of risk assessment, the management is required to carry out capital budgeting in its initial stages. IT businesses are also subject to investment risks. They are thus required to understand and use capital budgeting to identify possible risks to be able to reduce the effect. We will, therefore, discuss what capital budgeting is and how to estimate the best investment opportunity.

Capital Budgeting

Capital budgeting is the stage in which companies or businesses evaluate and determine potential large investments or expenses. The expenses may include activities such as building a new project, machinery or investing in long term ventures. Often, a business is required to assess the project prospects and lifetime cash inflows to determine whether the project will be worth as well as determine it will meet its targets. Ideally, a business should choose all projects that improve shareholder value. Some common valuation techniques such as net present value, payback period, internal rate of return and discounted cash flow can be employed to determine the expected income from an investment. Before investment, shareholders should also understand that the money they invest in a business in the present time is worth more in the future.

Time Value of Money

The TVM is a concept that show available money in the present compared to the similar sum in a time in future due to the ability of the money to earn. The main principle of finance shows that money provided for investment can either earn interest or profit. Thus, money is expected to be more over a period of time. TVM is also known as the present discounted value. The TVM concept states that if the sum of money owed in a time today has a greater value than the amount of money received at a time in the future. There are techniques used to compare and calculate the value of money in the future. They include capitalization, indexing, discounting, future value and present value.

Importance of TVM in Capital Budgeting

TVM is an important aspect of capital budgeting because it allows businesses to adjust cash flows. In the process known as discounting to present value allows the preferred amount of dollar received another time in the future. Some budgeting techniques that use time value include Net Present Value (NPV), Internal Rate of Return (IRR), and Project Profitability Index.

Project Profitability Index

The PPI is a metric used to determine project profitability index to determine which project should be preferred. The value of the project is obtained per every invested dollar. It is calculated by dividing the value of NPV obtained by the preferred investment. For the business to determine which project to invest in, they should choose the project with higher PPI value.

Internal Rate of Return

The IRR is a method of calculating the time value of money. It finds the discount rate given the project undiscounted cash flow that results from a zero net present value. The zero points of the undiscounted cash flow represent the breakeven point of the project profitability. The IRR is compared with the business minimum acceptable return rate. It is used in capital budgeting since it compares with the business minimum acceptable return rate.

Net Present Value

NPV is a common time value of money valuation techniques used to value money over a given time in the future. The matric is used to test the value of money in the future based on cash inflows or outflows required for a project. The NPV takes into consideration the cost of capital and risks associated with the project.

Portfolio Risk

Portfolio risk is the chance that a combination of units or assets in investment will fail to meet the set financial objectives. Every investment carries its own level of risk, the higher the risk may also mean that the investment will have a higher potential return. The Capital Asset Pricing Model (CAPM) is used to calculate the required return on investment. Since the CAPM formula is used to determine the required rate of return, it can be an important metric for determining expected portfolio risk.