Business Investment Decisions
The complex nature of business involves the understanding of both the internal and external factors that affect effective operation of an enterprise. Particularly, with the increased change in the methods used in risk evaluation and cost-cutting, many entities have resorted to the implementation of different techniques that will enable an increase in the level of competitiveness of the institution. As such, this study will illuminate on various concepts in business and how they affect the overall performance of the institution. Seemingly, some of them include capital budgeting, the time value of money and capital asset pricing model (CAPM).
Capital Budgeting and Time Value for Money (TVM)
Capital budgeting involves the process used by firms in making different decisions concerning long-run investment such as machinery, research development projects and opening of a new plan. Understandably, these investments are aimed at increasing the financial health of the company over a longer period. Capital budgeting ideas are usually developed by various stakeholder of the company including customers, suppliers, and employees who are able to identify a profitable opportunity for the organization (Zabarankin, Pavlikov, & Uryasev, 2014).
On the other hand, time value of money is a theory of management that emphasizes that the value of money available at the present time has more value than the same amount in a future date (Abor, 2017). This aspect is used in different areas including the valuation of the future worth of any investment that a business plans to undertake at present. Moreover, this principle emphasizes that as long as money has interest earning capacity; it is worth more when received than when saved for prospect use.
Importance of Time Value for Money to Capital Budgeting
The time value for money is an important aspect of capital budgeting as it helps in adjusting cash flows over a specified period. Additionally, the concept allows businesses to prefer the amount of money received today over a larger amount that may be received tomorrow due to the availability of different types of risks including inflation. Some of the aspects of TVM that are applied in capital budgeting include the calculation of net present value (NPV), internal rate of return (IRR) and project profit index (Abor, 2017). Equally, through understanding TVM business may be able to approximate the future net worth of their investment as well as projecting the average returns of the venture.
Potential Financial Investment Risks
In deciding on the type of investment to engage in requires proper evaluation of the prevailing risks and alternatives available. Understandably, all types of ventures have certain degrees of risk that determine the total expected income to be obtained after a specific period. Some of the potential risks existing in any type of project include interest rate, business, credit, taxability, inflammatory risk and market risk (Fernandes, Lynch Jr, & Netemeyer, 2014).
Market risk involves the possibility of the decline in the total net worth of the venture due to different economic developments or change of specific factors in the market. Some of the subcategories of market risk include interest rate, equity, and currency risks. Understandably, equity risk affects investment in shares where the average market price varies depending on the demand and supply patterns. Interest rate risk, on the other hand, affects debt investments including bonds and involves the uncertainty of losing money due to the abrupt change in the interest rates (Fernandes, Lynch Jr, & Netemeyer, 2014). Notably, Currency risk affects foreign investments and is brought about by fluctuations in exchange rates. For instance, the change in the value of the US dollar affects global exchange rate values for different currencies around the world.
Liquidity risk involves the inability to sell your venture at a stipulated value due to different aspects including the complexity of the business operations as well as the goodwill of the business. Moreover, credit risk involves the uncertainty that the government entity that offered the bond will be able to pay back the total amount invested including the principal amount plus the interest. Inflation risk involves the insecurity of losing the total purchasing power of the business since the investment is not able to cope up with frequent change in interest rates. Similarly, Business risk involves the measuring of the uncertainties associated with certain securities
Relevance of the Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is a business model that is used in determining the average rate of return of a particular asset which in turn helps in the decision making process on determining whether to increase the number of assets in a well-diversified portfolio (Zabarankin, Pavlikov, & Uryasev, 2014). Further, the model states that investments can experience two types of risks including the systematic and unsystematic risks
Systematic risks include the uncertainties that cannot be diversified and include recession and interest rates. Unsystematic uncertainties, on the other hand, can be diversified in different ways depending on the type of investment in question as the investor can increase the stocks in the available portfolio. As such, CAPM primarily deals with risks and returns of different financial securities. The average rate of return that an investor gets from purchasing a particular stock and holding for a specified period can be equated to the dividends and the capital gain received. With the ability to calculate the expected return helps entrepreneurs to decide on the types of securities to acquire over a given time.
The understanding of the different business models and strategies used to evaluate the risk available are important elements in determining the success of the enterprise. As such it is important for the management of the institution to ensure critical evaluation of the potential risks available before making an investment decision.
Abor, J. Y. (2017). Time Value of Money. In Entrepreneurial Finance for MSMEs (pp. 259-291). Palgrave Macmillan, Cham.
Fernandes, D., Lynch Jr, J. G., & Netemeyer, R. G. (2014). Financial literacy, financial education, and downstream financial behaviors. Management Science, 60(8), 1861-1883.
Zabarankin, M., Pavlikov, K., & Uryasev, S. (2014). Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2)..