Investment Appraisal Long Answer Type Questions
Question 1.
Explain risk and uncertainty.
Answer:
Profit is the reward for the entrepreneur and it is the balance left with the entrepreneur – after he makes the payment for all factor services. Profits are residual income left after the payment of the contractual records to other factors of production. According to Prof. Knight, profit is the reward for uncertainty bearing and taking risks. He distinguished between risk and uncertainty on one hand and predictable and unpredictable changes on the other. According to him only unforeseen changes can give rise to profits.
Risks are classified as insurable risks and non insurable risks. Examples of insurable risks are theft, fire and death by accident. Examples of non insurable risks are changes in price, demand, supply etc. According to Knight, profit is the reward for bearing non insurable risks and uncertainty.
The entrepreneur has to undertake production under uncertain condition. There is uncertainty regarding demand, price and cost. As there is a time gap between the period of producing and selling, many changes may take place during that period. If the entrepreneur enters into contractual agrement with the factor owners predicting rightly the uncertainty, he earns good profits.
If the predictions are wrong, he gets losses. Thus profit is a reward for uncertainty. Thus profit is a residual and non contractual income which accrues to the entrepreneur because of the fact of uncertainty. The entrepreneur is an unhired factor and he hires other factors for production. It is therefore, entrepreneur who .bears uncertainty and earns profit as a reward for it.
There are two types of changes which take place and are responsible for conditions of uncertainty. First type of changes refer to. the innovations (for e.g,. introducing of a new product or a new and cheaper method of production etc.) which are introduced by the entrepreneurs themselves. These innovations not only create uncertainty for the rivals or competitors who are affected by them but they also involve uncertainty for the entrepreneur who introduces ‘them, for one cannot be certain whether a particular innovation will be definitely successful.
The second type of changes which cause uncertainty are those which are external to the firms and industries. These changes are; changes in taste and fashions of the people, changes in government policies and Jaws especially taxation, wage and labour policies and laws, movements of prices as a result of inflation and depression, changes in production technology etc. All these changes cause uncertainty and bring profits, positive or negative into existence.
Only those risks can be insured against, the probability of whose occurrence can be calculated. An insurance company knows by calculation on the basis of past statistics, that how much percentage of factories will catch fire in a year. On the basis of this information, it will fix the rate of premium and is able to insure the factories against the risk. But there are risks which cannot be insured and therefore they have to be borne by the entrepreneurs. These non insurable risks relate to the outcomes of price output decisions to be taken by the entrepreneurs.
Whether it will pay him to increase output, reduce output and what will be the outcome in terms of profits or losses as a result of his particular output decision. Similarly, he has to face risks as a result of his decisions regarding mode of advertisement and outlay to be made on it, product variation etc. for taking all these decisions he has to guess about demand and cost conditions and always these is a risk of suffering losses as a result of decisions.
No insurance company can insure the entrepreneurs against commercial losses which may emerge out of decisions regarding price, output, product variation and also against losses which may fall upon the entrepreneurs due to the structural, cyclical and other exogenous changes which take place in the economy, It is, therefore clear that it is non insurable risks that involve uncertainty and give rise to profits.
To quote Knight, ” It is ‘uncertainty’ distinguished from insurable risk that effectively gives rise to entrepreneurial form of organisation and to the much condemned ‘profit’, as an income form’. However this theory is unrealistic as it fails to separate owner and salaried manager.
Question 2.
Discuss measurement of risk.
Answer:
Accurate measurement of derivative-related risks is necessary for proper monitoring and control. All significant risks should be measured and integrated into a entity-wide risk management system. The risk of loss can be most directly quantified in relation to market risk and credit risk (though other risks may have an equally or even greater adverse impact on earnings or. capital if not properly controlled). These two types of risks are dearly related since the extent to which a derivatives contract is “in the money” as a result of market price movements will determine the degree of credit risk. This illustrates the need for an integrated approach to the”risk management of derivatives. The methods used to measure market and credit risk should be related to:
- the nature, scale and complexity of the derivatives operation
- the capability of the data collection systems and
- the ability of management to understand the nature limitations and meaning of the results produced by the measurement system.
Mark-to-market:
The measurement process starts with marking to market of risk positions. This is necessary to establish the current value of risk positions and to recognize profits and losses in the books of account. It is essential that the revaluation process is carried out by an independent risk control’unit or by back office staff who are independent of the risk-takers in the front office, and that the pricing factors used for revaluation are obtained from a source which is independently verifiable.
Measuring market risk:
The risk measurement system should assess the probability of future loss in derivative positions. In order to achieve this objective, it is necessary to estimate:
(a) the sensitivity of the instruments in the portfolio to changes in the„ market factors which affect their value (e.g. interest rates, exchange rates and volatilities); and
(b) the tendency of the relevant market factors to change based on past volatilities and correlations.
The assumptions and variables used in the risk management method should be fully documented and reviewed regularly by the senior management, the independent risk management unit and internal audit.
Question 3.
Explain different tax system of international risk management.
Answer:
A tax (also known as a “duty”) is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (e.g. tribes, secession istmovements or revolutionary movements). Taxes could also be imposed by a subnational entity.
Taxes consist of direct tax or indirect tax, and may be paid in money or as corvee labor. In modern, capitalist taxation systems, taxes are levied in money, but in-kind and corvee taxation are characteristic of traditional or pre-capitalist states and their functional equivalents
Risk management is the process of measuring, or assessing, developing strategies to manage it. Strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Traditional risk management focuses on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death, and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments
(1) Establishing the context: It includes planning the remainder of the process and mapping out the scope of the exercise, the identity and objectives of stakeholders, the basis upon which risks will be evaluated and defining a framework for the process, and agenda for identification and analysis of risk involved in the process.
(2) Identification: After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.
(3) Assessment: Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring.
Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is Rate of occurrence multiplied by the impact of the event equals risk
(4) Potential risk treatments: Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories: (Dorfman, 1997) (remember as 4 T’s)
- Tolerate (aka retention)
- Treat (aka mitigation)
- Terminate (aka elimination)
- Transfer (aka buying insurance)
Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organization or person making the risk management decisions.
(5) Risk avoidance: Includes not performing an activity that could carry risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.
(6) Risk reduction: Involves methods that reduce the severity of the loss. Examples include sprinklersdesigned to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable.
(7) Risk retention: Involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible.
War is an example since most property and risks are not insured against war, so the loss attributed by . war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much.
(8) Risk transfer: Means causing another party to accept the risk, typically by contract or by hedgingInsuranceis one type of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. On the other hand, taking offsetting positions in derivatives is typically how firms use hedging to financially manage risk.