Risk Analysis on Investment Decisions
Risk Analysis on Investment Decision Silicon Arts Inc. (SAI) is a four year old company that manufactures digital imaging integrated Circuits (IC’s) that are used in digital cameras, DVD players, computers, and medical and scientific instruments. Hal Eichner, SAI’s Chairman, has a two-point agenda for the company to increase market share and keep pace with technology. As the Financial Analyst for the company one must analyze two mutually exclusive capital investment proposals. The two options are to expand the existing Digital Imaging market share or enter the Wireless Communication (W-Comm) market (UOP Simulation, 2008).
Shareholders in organizations like to invest in projects that are worth more than they cost. The difference between the two is called Net Present Value (NPV). Assuming you will be maximizing the shareholders wealth, when calculating the NPV, the project with the positive outcome will be the project that should be pursued. In capital budgeting, the profitability index (PI) measures the dollar return for the amount invested. Hence, PI is useful for capital rationing (Ross, et al, 2005, p. 14). The investment in net working capital is an important part of any capital budgeting analysis. NPV calculates all cash flows rather than profits, however, used alone can result in a false sense of security (Ross, et al, 2005, p.4).
In capital budgeting there should not be total confidence placed in NPV calculations alone, several analysis’ exist to provide additional support for goof investment analysis. The sensitivity analysis is one approach, which examines how sensitive a particular NPV calculation is to changes in underlying assumptions (Ross, et al, 2005, p. 22). A downside to sensitivity analysis is that it treats each variable in isolation. Scenario analysis, a variant of sensitivity analysis allows several factors to be considered at the same time. Break-even analysis helps to narrow the project selection by calculating the amount of sales needed
Shareholders in organizations like to invest in projects that are worth more than they cost. The difference between the two is called Net Present Value (NPV). Assuming you will be maximizing the shareholders wealth, when calculating the NPV, the project with the positive outcome will be the project that should be pursued. In capital budgeting, the profitability index (PI) measures the dollar return for the amount invested. Hence, PI is useful for capital rationing (Ross, et al, 2005, p. 14). The investment in net working capital is an important part of any capital budgeting analysis. NPV calculates all cash flows rather than profits, however, used alone can result in a false sense of security (Ross, et al, 2005, p.4).
In capital budgeting there should not be total confidence placed in NPV calculations alone, several analysis’ exist to provide additional support for goof investment analysis. The sensitivity analysis is one approach, which examines how sensitive a particular NPV calculation is to changes in underlying assumptions (Ross, et al, 2005, p. 22). A downside to sensitivity analysis is that it treats each variable in isolation. Scenario analysis, a variant of sensitivity analysis allows several factors to be considered at the same time. Break-even analysis helps to narrow the project selection by calculating the amount of sales needed
References: Ross, S., Westerfield, R., & Jaffe, J. (2005). Corporate finance 7ed. [University of Phoenix Custom Edition e-text]. New York: The McGraw-Hill Companies. Retrieved April 20, 2008, from University of Phoenix rEsource, MBA 540—Maximizing Shareholder Wealth Course Web site. Sick, G. (2006). Investment Decision Analysis. Retrieved on April 20, 2007 from http://www.ucalgary.ca/~sick University of Phoenix. (2008). Capital Budgeting Simulation. [Computer Software]. Retrieved April 20, 2008, from University of Phoenix, rEsource, Simulation, MBA540—Maximizing Shareholder Wealth Web site.