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In Capital Budgeting Simulation, Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI) can be analyzed two mutually exclusive capital investment proposals. Silicon Arts Inc. (SAI) is a four-year-old company, manufactures digital imaging integrated Circuits (ICs) that need to analyze two capital investment proposals to pursue its growth plans. "SAI’s Chairman is planning to increase market share and keep pace with technology, which can be done by either expanding the existing Digital Imaging market share or entering the Wireless Communication market," (Simulation, UOP). An analysis reveals that an expansion into the Wireless communication can be beneficial than Dig-Image. However, a number of risks, internal and external are inherent in joining this industry. This paper will analyze investment risk decisions and mitigation of risks by using a number of strategies.
One risk associated with cost of capital in W-Comm proposal will be excess real estate at the Santa Clara plant that can be used the cost of capital $18 million in the first three years. “Cost of capital is the rate of return that SAI could be able to earn at the same risk level as investment that has been selected” (Ross-Westerfield-Jaffle, 2004). SAI can mitigate this risk through liquidity enhancements by bringing uninformed investors. Company should use stock splits which makes a round lot more affordable small businesses and uninformed investors by facilitating stock purchases. SAI can be lower its cost of capital and acquiring liquidity by offering its stocks through internet. Direct stock purchase plans and Dividend reinvestment programs in online allow small investors the opportunity to buy securities cheaply, disclose more information and this narrows the gap so that it reduces SAI’s cost of capital.
According to Marketing Research Reports outline, SAI should use the best capital budgeting approach (NPV) that identify cash flows rather than profits, uses all the cash flows and discounts the cash flows properly. Cash flows forecasts for SAI underlying revenues, cost, and after tax cash flows. Sales projections for market forecast can estimate depend on market share, price per product and size of market. It is also considered variable cost and fixed costs. “Variable costs change as the output changes such as direct labor cost and raw materials are variable while fixed costs are measured as cost per unit of time such as time or salaries” (Ross-Westerfield-Jaffe, 2004).
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As SAI becomes increasingly global, it must aware of foreign exchange exposure and implement appropriate hedging strategies. Changes in exchange rates may affect not only the operating cash flows of a firm but also dollar values of the firm’s assets and liabilities. SAI should consider the currency effect on its overall future cash flows that manage operating exposure by selecting low-cost production sites, flexible sourcing policy, diversification of the market, product differentiation and R & D efforts and financial hedging. Wireless Communication is exposure with market risk that is made up of the uncertainties of changes to market prices or rates. Market risk is divided into systematic and unsystematic risk. “Systematic risk is any risk that affects a larger number of assets, each to a greater or larger degree, and unsystematic risk is the risk that specifically affects a single asset or small group of assets” (Ross-Westerfield-Jaffle, 2004). By preparation and forecasting helps reduce the level of risks for each and a well diversified portfolio will most likely be the most optimal way to reduce risk.
The internal capital markets hypothesis predicts that capital investments may create more economic value for diversified firms than for focused firms. Firm’s managers can broaden their internal capital market and gain these economies by diversifying. Therefore, diversified firms allocate resources more efficiently because they create a larger internal capital market and most likely to make positive NPV investments. Diversification is a logical way to reduce market risk. SAI can lessen this risk that mixes a wide variety of investments within a single portfolio. It asserts that a portfolio of different kinds of investments will on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio (Sheng-Syan, 2006). Cross-sectional regression analyses demonstrate a significantly positive relation between the market's responses to capital investment announcements and the degree of corporate focus.
Another way financial risk can be mitigated by using Capital Asset Pricing Model (CAPM).This is the relationship between risk and expected return for valuing stocks, securities or assets. SAI can use the tools to estimate the firm’s cost of equity capital by using risk free rate, market risk premium and the company beta. SAI measures asset risk by the variance of its return over future periods. In a portfolio, two assets are considered to be hedged if they have a negative correlation whereby a loss in one result in a simultaneous gain in the other (Ross-Westerfield-Jaffle, 2004). In addition, SAI must aware interest rate risk that emphasizes the ability of the firm to generate enough income to cover interest expenses. Since, the expected life for this new W-Comm investment will be seven years, SAI considers to get fixed loan.
Risk analysis helps SAI to evaluate a more educated investment decision by using the methods of cost of capital, CAPM, financial leverage and average return on market portfolio. Risk assessment is necessary part of making capital budget decisions more objectively. The
company believes that indicators on the market proposal, adjusting NPV, IRR and PI in general are critical to the SAI decision. Financial analysis such as currency risk, capital risk and liquidity risk is considered in entering wireless communications market implementation that determined the final outcome.
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