Assessing the Risk in Three Potential Investments
The way an investment is assessed will include consideration for the level of risk that is present in that investment. The higher a risk associated with a business the higher the required rewards referred to as the risk and reward equation. Where the risk premium increases this will also lead to the use of increased discount levels in discounted cash flow assessments, such as net present value (NPV) calculations. In order to consider the way this may be applied to investment decisions three different business plans may be assessed; Acme Consulting, Interstate Travel Center and Silvera and Sons.
Risk may be assessed using a number of different criteria. From the perspective and an investor, or lender, the key aspect of risk will be the determination of whether or not the money invested or loaned will be returned and whether is will make a profit sufficient to justify the risk (Berry, 2012). This also incorporates an assessment of the viability of the business and the potential financial returns (Reilly and Brown, 2011). The aspect of opportunity cost may also be considered, as an investment in one company may be seen as risk in terms of the potential returns which may have been gained elsewhere where investments are mutually exclusive (Nellis and Parker, 2006).
The first of the firms is Acme Consulting. This is a start up firm offering premium consulting services to large high tech manufacturers, such as IBM and HP, and a secondary market of medium sized media businesses, with a head office in the renowned Silicon Valley area; placing them in a key area. The firm is being established by individuals with relevant knowledge in the relevant areas of marketing a consultancy as well as the high tech industry. It is noted that the market for these services is currently fragmented which may provide opportunities, With related diversification of services, including retainer work, market research and project consulting the firm will be able to offer a full package of services. The sales patterns are expected to vary over a year, rather than remain level.
The financial aspect of the firm is very important when assessing risk (Reilly and Brown, 2011). The company requires a relativity small level of capital investment compared to the next two cases, and on an operating basis will break even in the first year (during month 9 calculated using the operating profit). However, profit within the first few years is relatively low, it is minimal in the first year and although it is increasing, by year 3 the net profit reaches $65,000, equating to a 6% profit margin. This limited the potential return on investment for investors.
The task may also be assessed with reference to potential security that the firm may provide. A key concern with Acme may be the low level of physical assets which is being created, providing little physical security for any investment, In terms of risk it may also be noted that the firm has not yet been incorporated, as such any agreements between the firm and an investor may be risky as the firm does not yet have its own legal personality. Overall, Acme may be using only a small level of capital, but they are creating limited assets as security and the return they are creating is constrained. In addition the current start up status of the firm, which is yet to be incorporated, may be seen as adding additional risk.
Interstate Travel Center
The Interstate Travel Center involved the development and then operation of services and amenities of truck drivers, including gas sales, a convenience store and restaurants. The location will be on a busy interstate, where there is a high level of potential passing trade with only limited local competition available. There is also the potential for further growth with the development of a ‘Port To Plains’ corridor increasing the traffic to the locations, but this is not assured. This may offer a potential but as it is not assured it should not be considered in the assessment.
The plan itself benefits from the essential nature of many of the services offered and lack of nearby competition. The experience of the couple setting up the business is also a benefit. However, as with Acme, this is also a start up business. There is also a danger sign in the projections, where the estimated gross profit margin is 26%, which is 10% higher than the industry average. This may indicate a superior return, but it may also reflect a potentially over optimistic projection. This may be explained by the large range of services to be offered.
The financial performance projections indicate that the firm should provide an operating profit from the first year. A key difference between Acme and Interstate Travel is the capital structure and the assets. The Interstate Travel Centre is taking on a high level of long-term debt, with $2.5 million out of the required $2.75 million being on the form of a loan. The firm will also have more security with the purchase of assets, such as the land and the development of the service station. However it should also be remembered that despite these assets, a loan of this size is likely to be secured and receive priority over money owed to investors.
Therefore, as a start up business without a history in the same business this may also be seen as risky, however unlike Acme there is the creation of a physical business with a higher level of physical assets.
Silvera and Sons
The last business is that of Silvera and Sons; a coffee export business that wishes to expand its capacity. The existing nature of the business may be seen as reducing the risk profile; the management has already proven their ability to manage the firm and create profit, seen with the previous six years of profit, also proves their knowledge of the industry.
However, this does not mean the plan is without risk, the firm has a high reliance on only two importers in the U.S., if there are internal changes to these importers the firms could face challenges. There is also a high level of competition in the market, and to leverage the new investment in the expansion the firm will need to gain new customers. The risk is also seen in the high debt ratio.
Overall, although there are risks, the Silvera and Sons investment may be seen as the lowest risk, requiring the lowest return or discount rate, with the firm benefiting from the existing nature of the business and the investment into resources that will provide for security. The Interstate Travel Center is more risky, it is a new venture that is being started with no track record and owners that have relevant experience in only some areas of the operations. However, there is the benefit of the loan being used to buy and develop land, creating security which is also likely to benefit from added value as it is developed. Therefore this is placed at the medium level of risk, due to the asset creation as security. The highest risk Acme, this is a start u which is not yet incorporated the investment is creating only a few assets and there is a high level of reliance on intangible assets, such as knowledge. For this reason Acme should have the highest risk premium and require the highest discount rate in assessing the business.
Bplans, (2012), Coffee Export Business Plan, Silvera and Sons, retrieved 10th June 2012 from http://www.bplans.com/coffee_export_business_plan/executive_summary_fc.php
Bplans, (2012), High-Tech Marketing Business Plan, Acme Consulting, retrieved 10th June 2012 from http://www.bplans.com/high-tech_marketing_business_plan/executive_summary_fc.php
Bplans, (2012), Truck Stop Business Plan, Interstate Travel Center, retrieved 10th June 2012 from http://www.bplans.com/truck_stop_business_plan/executive_summary_fc.php
Berry T, (2012), Buying a Business? Know What You Are Getting! Bplans, retrieved 10th June 2012 from http://articles.bplans.com/buying-a-business/buying-a-business-know-what-you-are-getting
Reilly, Frank K; Brown, Keith C. (2011) Investment Analysis and Portfolio Management, South-Western College
Nellis JG, Parker D, (2006), Principles of the Business Economics, London, Prentice Hall.
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