Business Risks that Affect the Valuation of Early-Stage Investment - Case Study Example

Student’s Name Instructor’s Name Date Course Real versus Financial Options in the Risk Management Strategy of an Early-Stage Biotechnology Investment. Introduction. Risk is part of the business. All businesses – new, established, small or big – face various risks all the time. Risks can be financial or operational. Financial risks pose various threats related to the value of money in relation to such factors as the interest rates as well as the time value of money. Operational risks relate to the challenges associated with various factors of production. In new businesses, these factors affect the valuation of the investment. The higher the severity of the uncertainties the bigger the impact on the investment valuation. Alexander Triantis, 2000, identifies several types of business risks that affect the valuation of early-stage investment, and in different ways. Interest rate risk exposure. Interest rates are always subject to changes, unexpectedly, and it can have negative impacts on the investment valuation. Majorly, the level of exposure depends on the interest rate options involved in borrowing (Triantis, 64-68). If the company issues bonds, the exposure is limited to the fixed interest rate involved. However, if the company borrows on the basis of floating rates, the risk exposure is higher given the variability of the rate. In the long-term, the fixed-rate debt is subject to the exposure to the fall of the long-term interest rates. On the other hand, the float-debt rate exposes the investment to the short-term interest rate rises. Besides, the early-stage biotechnology investment may face the risk of interest rate changes between the point of the borrowing need identification and the point of the real borrowing transaction date. The impact of the interest rates exposure on the valuation of the early-stage biotechnology investment is dependent on the liabilities and the assets affected by the interest rate fluctuations. If the gap between the value of the interest-sensitive assets maturing at a specific time and the interest-sensitive liabilities maturing at the same time is negative, the value of the investment will reduce in direct proportions. However, if the otherwise happens, the value of the investment will increase accordingly (Triantis, 64-68). Performance risk. The early stage biotechnology investment also faces the performance risk. The performance risk is the uncertainty about the suitability and ability of the project to accomplish the intended performance, failing to achieve the justified its commencement. Mostly, the performance risk is caused by the technological problems leading to increased cost and duration of the project. Currently, the analysis of the performance risk is conducted via the use of quantitative models and methods. If the investment experiences higher costs than the estimations, the value of the cash flow will record negative figures, and the value of the investment would lower. A similar impact will be felt if the duration of production increases more than the estimations (Triantis, 64-68). Legal and regulatory risks. Legal risks include the uncertainties of having to comply with new legislative policies in the future. Changes in business laws have the impact of increasing the cost of business, and may result in the low competitiveness of the business as well as reduced investment attractiveness. The legal requirements for the environmental and human health protection come with additional costs for business. The new requirements may require the business to incur additional costs in the prevention/control/elimination/reduction of discharges and emissions into the environment. Some requirements may lead to the introduction of the environmental contamination remediation costs. Others may require the compensation of individuals or organizations that claim damages. The emergence of new requirements sensitive to the biotechnology products would hurt the market. The emergence of new requirements that require the application of costs for compliance affects the cash flow. Both the two situations would reduce the overall value of the investment (Triantis, 64-68). Legal and regulatory risks are significant determinants of the value of the business. For the early-stage biotechnology investment, the legal and regulatory risk would affect the valuation in two different ways. Product liability risk is associated with the defective products. The product liability law places the manufacturer as the liable party in case the product turns out to be defective. The early-stage biotechnology investment is also exposed to this risk, and the company can be indicated as negligent if the products cause injury to the consumer. The product liability risk affects the cash flow and thus lowering the book value of the investment (Triantis, 64-68). Technological uncertainties affect all the operations in the organization, spans all the organizational operations. Technology is the key factor that determines how the business processes take place (Shockley, Curtis, Jafari, and Tibbs, 7-10). As a result, the risks pertaining to technological issues cannot be compartmentalized. Technology risks are threats to the business processes and assets. Exposure to technology risks to the early-stage biotechnology investment would reduce the investment value. Another risk identified by Triantis (2000) is product demand risk. This type of risk affect all forms of business during the entire period of operations. It results from the use of the forecasted data for the product demand determination (Triantis, 64-68). Since the predictions are not accurate, the market may exhibit excess or less demand than the company’s production. Too little demand is deleterious to the company’s endeavours because it results in negative cash flows. However, if the demand is too much the company may adjust accordingly to meet the demand. The early-stage biotechnology investment also faces the product demand risk. If there is a shortfall in demand, the effect of the valuation of the investment would proportionately be reduced. On the other hand, excess demand would increase the value of the investment (Shockley, Curtis, Jafari, and Tibbs, 7-10) Real and financial options of risk management strategies for the early-stage biotechnology investment (comparison). Similarities between real and financial options of risk management. Both real and financial options of risk management strategies can limit their downside risk while at the same time maximizing the profit. The use of either the real or the financial options in risk management ultimately hedges various classes of the firm’s risks. Resultantly, the firm enjoys reduced variance of the future cash flows. Besides there is an increase in the expected values of the cash flows in the future. Another similarity between the financial and the real options of risk management is that both of them allow the firm’s limitation of the losses through the provision of an option to exit. For the real options, the loss can be limited through an application of the least costly methods of exit. On the other hand, the one can limit the loss from the use of financial derivatives by following the least risk prices at the exit point (Triantis, 69-71). Differences between the real and financial options of risk management. Although both the real and the financial options of risk management involve various elements of cost, real options can be tailored to avoid all costs. For the firms to delay projects or walk off the failing projects, they need to create barriers that are preventive of the entry of other firms in the market during the delay period. Besides, they ought to design adequate overlay strategy to hedge the exchange rate risk exposure during the delay period. Additionally, the real options of risk management cause alterations of the firm’s risk profile whereas the financial options can hedge the firm’s risk by addressing the residual risks that are likely to have negative impacts on the overall firm as well as the real options’ value. A difference of the financial and real options o risk hedging is also exhibited by the difference in the target type of risk for each of the approaches (Triantis, 69-71). If the target risk is currency exchange rate exposure, the real options will make up the most appropriate, and competitive method of effective risk hedging. However, if the target risk class is transactional, the most suitable method of hedging the risk would be the use of financial derivatives. The use the financial derivatives allow the company to transfer its exposure to other parties, and thus to make it immune to the associated losses. On the other hand, the real options of risk management increase the flexibility of the company and thus allowing it to avoid various classes of risk without the involvement of other parties (Triantis, 69-71). Reasons/justifications for the use of integrated risk management strategy. The combined use of both the financial options and the real options of risk management conveys several benefits to the company making it suitable for the business to adapt the integrated risk management. The use of the integrated risk management strategy allows the firm capitalize its opportunities. The use of the integrated risk management strategy allows the firm to examine the both the positive and the negative nature of risks, and thus the nature of all opportunities. Different opportunities have different benefits and risk levels. By weighing the positive and the negative significance of the opportunity to the business, it is possible to select the best option for the investment of the firm’s resources. As a result, the firm gains the capability to capitalize the opportunities for maximum benefits. The use of the integrated risk management strategy is also justified by its ability to bring the management decision’ improvement. The improvement of the management decision from the use of the integrated risk management strategy is provided by the knowledge of the level and the type of the risk facing the organization (Deventer, Donald, Kenji and Mark, 48-51). Consequently, it is possible to perform more realistic analysis to substantiate the managerial decisions. One of the specific benefits of integrated risk management strategies to the decision-making process is agility. Integrated risk management strategies promote numerous alternatives for use in different case scenarios. It allows the firm to consider using various financial risk hedging methods in combinations with operational approaches to hedging risk. In that vein, the decision-making process would be based on the existing alternatives as well as the various target objectives. Additionally, the integrated risk management offers insurance of the organizational strategy’s risk profile. The risk appetite is descriptive of the limits to which risk is acceptable as well as to the exposure of the organization. With the integrated risk management strategy, the organization gains access to the opportunities of achieving the goals as well as make the selection of the most suitable options depending on the prevailing risk profile (Deventer, Donald, Kenji and Mark, 48-51). This form of insurance from risk allows the business to increase its operations within the prescribed limits where the integrated risk management strategy offers loss prevention to the business. The use of the integrated risk management strategies is also preferable because it allows the establishment of internal control measures to enable handling of at least one risk that may be present in more than one of the organization’s functional structures. Some forms of risk span many functional structures of the organization. Internal controls define the extent to which each of the risk management practices – financial and operational – can be applied to hedge the risks that span many organizational units. The use of integrated risk management strategies creates a competitive advantage for the business. It allows the business management analyse the prevailing risks and apply combinations of both the operational and the financial risk hedging practices to ward off or neutralize risks. By effectively wording-off or neutralizing risks, business gains a profitable position and the ability to sustain its business endeavours. Summarily, the business gains a competitive edge in the industry (Doherty, 35-39). Conclusion. The valuation of the early-stage biotechnology investment is significantly affected by several risks namely technological, interest rate, performance, legal and regulatory factors. Risk management strategies that could be used to avoid negative implications on the value could be operational or financial in nature. However, integration of both financial options and operational strategies in hedging risk is the best approach to realizing the most favourable results. The use of integrated risk management allows the firms to realize more benefits than the specific use of either the financial options or the operational approaches. Work cited. Deventer, Donald R, Kenji Imai, and Mark Mesler. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Singapore: Wiley, 2013. Internet resource. Doherty, Neil A. Integrated Risk Management: Techniques and Strategies for Managing Corporate Risk. New York: McGraw-Hill, 2000. Internet resource. Shockley, R L, S Curtis, J Jafari, and K Tibbs. "The Option Value of an Early-Stage Biotechnology Investment." Journal of Applied Corporate Finance. 15 (2004): 44-55. Print. Triantis, Alexander J. "Real Options and Corporate Risk Management." Journal of Applied Corporate Finance. 13.2 (2000): 64-73. Print. Read More