Real vs. Financial Options in the Risk Management Strategy - Coursework Example

Author’s Name Instructors’ Name Course Date Real vs. Financial Options in the Risk Management Strategy Introduction In any financial investment, financial risks are involved. Therefore, some degree of risk must be considered when making financial decision, especially when financial investments are made. Financial risk management refers to the practices that enable a firm to optimize how it takes financial risk. Some of the elements involved in the financial risk management include determining how the company will monitor risk operations or activities. The following paper intends to first focus types of risks as described in Triantis. Secondly, an analysis of the risk management strategies for the early‐stage biotechnology investment by Wahoo Genomics has been provided. However, in order to minimize future financial risks involved in the project, the paper recommends the use of debt and equity instruments. Identifying the Type of Risks Business risks are some of the core components that any company or organization should take into consideration to avoid the backlash of business activities or operations. Commodity price, fluctuation of interest rates and currency of a country are critical elements when profiling risks of a business initiative (Triantis 2000). However, there is a wide range of other risks that should be taken into account. The following section intends to analysis technological, economic, and financial, performance, and legal or regulatory risks. Technological risks mostly arise in the processes of research and development as well as operational stages in the value chain of a firm (Triantis 2000). The continued increase in the dependence on the technological progress in many industries has widened the type of risks encountered as well. The profitability of any organization including those dealing in the high-tech and pharmaceutical industries is determined by how risks are controlled and managed in the processes of research and development. It is important to note that companies should ensure that the kind of technology used is up to date in order to avoid continued breakdowns. However, technological risks also rise if new technologies used by a firm are not well or fully integrated in the firm’s operations (Triantis 2000). The net result is that the delivery of services and outcome is heavily affected. Using old systems means that research and development processes s will take time and the organization might be forced to use more money in the end. Some of the expected risks as a result of technological failure include accidents, fires, major breakdowns, and force majeure risks such as floods and earthquakes. Further, defective output can as well be experienced by a firm, leading to the product liability suits (Triantis 2000). The valuation of the early‐stage biotechnology investment is as well dependent on the cost of technology used in the research and development. Economic risks vary form one aspect to another. There a couple of components that include economic position of a firm or an organization(Triantis 2000). The change of currency is one of the determinant factors that affect the cost of production and the value of revenue. The company needs to take into consideration the fluctuating of cost of production that is also included by several elements. Labor and cost of material determines the overall cost of production and the net price of products and services in the market. Consequently, the price tagged to the product is dependent upon the production cost (Triantis 2000). On the other hand, the cost of a product determines the demand level, which influences the revenues of a firm. Despite the fact that general microeconomic conditions will significantly affect these variables, such as the gross domestic product of a country, the competitive nature of a firm and the market environment also determine the kind of economic risks to be exposed to. However, a firm can apply of the Michael Porter’s five forces model that offers a framework of examining the strategies of increasing the profit margin in a competitive environment (Triantis 2000). The model is also instrumental in pinpointing the genesis of revenue and expense risks. The application of economic factors such as labor, cost of services and materials used should be factored in the valuation process. However, the application of risk-free discount rate and risk-neutral probabilities to backdate the cost of the investment made is instrumental in determining the value of the investment as at 2007. Further, financial risks are some of the core elements in the financial management of any business (Triantis 2000). It is critical to note that non-financial corporations are also at a risk of experiencing financial risks. Several components are associated with influencing the financial risks of a business. One of such elements is the fluctuations of interest rates. The exposure to interest rate is found in many business firms. The cause of the exposure is due to the mismatch in the sensitivity aspect of the organization’s assets or alternatives of growth. In this connection, the influence of currency fluctuations is as well felt at an organizational level. The exposure to the currency exposure risk is thus present in every business (Triantis 2000). The value of buying and selling of materials and products is dependent upon the strength of a country’s currency. For this reason, the cost of production is affected if the currency is not performing well. The normal trend is that foreign companies are known to take advantage of weak currency and exploit the local firms, which brings competitive risks. Further, financial market risk can as well influence the firm’s risk profile especially if a company holds financial securities (Triantis 2000). Although the inflation rate is not being considered since the real cash used in the valuation process, it is clear that the value of the investment made is highly dependent on the currency position in 2007. Additionally, companies continue to enter into ling term contracts with other stakeholders such as suppliers, subcontractors and buyers (Triantis 2000). The partnership with these parties increases the risk of performance where some stakeholders may fail to perform their duties in the agreement. Failure to perform contractual obligation can result into financial loss of a business or an organization. In this respect, subcontractors may delay the delivery of important elements or compromise the quality of product or service being produced by the company (Triantis 2000). On the other hand, buyers may decline to buy the products or services, thus affecting the company’s revenue. Moreover, financial institutions may as well default their financial obligations. It must be appreciated that writing complete contracts that cover all contractual obligation and reducing the risk involved is a complicated process. In addition, it is also highly uncertain to speculate the judicial process and compiling the damages caused through breaching the contract (Triantis 2000). Therefore, companies or firms should ensure that performance contracts with all stakeholders are taken into consideration to minimize the risks involved and consequently financial loses. The initial penetration rate of the drug is estimated to be 3%, which is expected to hit 50% by 2017. However, the potential buyers may alter the expected market performance of the drug. Consequently, failure to buy the drug means that buyers will have breached the contract, leading to the loss. Finally, businesses are also faced with legal and regulatory uncertainties (Triantis 2000). The importance of regulatory and legal uncertainties cannot be underestimated since companies are subject to laws and regulations set by the state. The change or enacting of business laws and regulation influences the performance of any company. Environmental laws for instance are some of the regulations that can impose considerable cost to some firms (Triantis 2000). However, the same laws can lead to the increase of profit margin of other companies. Further, tax laws and changes can influence the after tax profitability of a firm. On the same note, firms that establish projects in foreign countries are likely to be affected by the business laws and regulation in the foreign nation. Finally, political instability in the foreign country can result to the expropriation of assets or other claims in such countries. The estimation made Wahoo Genomics the investment will cost $10 including the establishment of facilities and system of production and distribution respectively. However, the food and drug administration, which regulates approval process, can change the required laws and regulations thus influencing the overall cost of the investment. Comparing and Contrasting the Real and Financial Options The following section intends to discuss various risk management strategies that can be used in the early‐stage biotechnology investment (Hull 2012). Several options can be applied in order to reduce financial risk involved in the research and development of the drug. Several options of reducing financial risk for the Wahoo Genomics exist. The most common is making use of equity and debt funding alternatives (Hull 2012). The common element involves using debt and equity instruments in raising the capital needed. Equity and debt instruments also come in different categories. However, the common equity instrument is the selling of shares in stock markets. Investors are always searching for any promising companies to invest their money (Hull 2012). Therefore, Wahoo Genomics can sell its shares to investors in future in order to get capital, which can be used in R&D process. On the other hand, foreign exchange business is also another alternative that a Wahoo Genomics can use to minimize its financial risk. The most common form of debt market is the corporate debt market, which involves selling of bonds to potential investors (Hull 2012). It must however be underlined that there are factors that determine trust investors have on the corporation, including the type of management, future prospects and previous financial performance. However, it must be agreed that one of the common ways in ensuring that Wahoo Genomics minimizes the financial risk is through diversification. Financial risk management through diversification requires that a company invest in several ways to get revenue (Hull 2012). The common method of diversification is splitting money based on the risks involved. Twenty-five percent can be invested in low risk markets while another 25% can be put in government bonds. Further, Wahoo Genomics can invest 30% in the derivatives or domestic market and 20% in the international market instruments. The main objective is to ensure the company spreads financial risk through several safe and risky investment alternatives (Hull 2012). Financial Risk Management through Debt and Equity Instruments As noted above Wahoo Genomics can use debt and equity instruments to fund their operations and minimize financial risk involved in the project. The two forms of funding are based on the investors’ confidence in the company (Hull 2012). One of the advantages of equity instruments is that they provide opportunity for capital gains based on the appreciation. However, in this case, investors bear risks of losing if the corporation’s share price drops. Selling of Wahoo Genomics share depends on the asset value of the company. The valuation of the asset determines the volume of shares that are going to be floated in the stock market. Based on the number of shares available, the price of single package of shares is determined and investors are invited to put their money. The repayment agreement is determined based on the profit made by the firm (Hull 2012). If the corporation is making good profits, the investors are also likely to make good earnings depending on the interest rates. However, investors have the right of ownership, based on the percentage of shares held. Further, Wahoo Genomics can as well provide for warrants in buying of stock. Provision of warrants means that an investor is only expected to buy common shares at a specific price and time (Hull 2012). Wahoo Genomics can use this strategy to dictate the volumes of earnings expected from the investors. The strategy is also used to avoid speculations and unhealthy competition. Conclusion Risk management is critical in any file of investment. Wahoo Genomics’ investment in the early‐stage biotechnology project. However, it is evidently clear that a couple of risks need to be considered including economic, financial, performance, technological, and legal or regulatory risks. The risks can be minimized through diversification, as descried above. References Hull, J. (2012). Risk management and financial institutions. Hoboken, N.J., John Wiley & Sons. Shockley Jr. ( 2002).The Option Value Of An Early‐Stage Biotechnology Investment , Journal of Applied Corporate Finance. Volume 15, Issue 2, December 2002, Pages: 44–55 Triantis, J. (2000). Real Options and Corporate Risk Management, Journal of Applied Corporate Finance. Volume 13, Issue 2, Summer 2000, Pages: 64–73. Read More