(a) “Total Risk Management (TRM) will become a common term in finance just like Total Quality
Management (TQM) has in production and marketing.” (Professor Andrew W. Lo. 1999).
(i) Define risk management as used in finance.
(ii) Discuss reasons why risk management might increase shareholders wealth.
(b) Kasuku Limited has set aside Sh. 40 million for investments as on 1 January 2004. Five proposals are
presented to the company‟s board of directors the finance manager as shown below:
1. Projects D and E are mutually exclusive.
2. Each project is divisible and can only be undertaken once.
3. Variable costs are 40% of annual revenue.
4. All cash flows will occur at the end of the year commencing 31 December 2004.
5. Cost of capital is 10% (ignore tax).
i. Determine the optimal allocation of the Sh. 40 million amongst the five projects.
ii. What is the net present value resulting from this allocation?
(a) (i) In the context of Financial Management, risk management involves identification of events and occurrences that could result in adverse financial consequences and negatively affect shareholders‟ wealth and then take convective actions to prevent or minimize the negative consequences of such events.
(ii) Risk management would increase shareholders wealth in the following ways. ensuring reduction in transaction costs and foreign exchange losses.
Lower interest changes managing interest rate risk through options interest rate futures interest rate swaps etc.
Lower volatility of cashflow generated projects hence higher stock prices
Tax shield – stable earnings ensures more tax credit compared to volatile earnings Stability of cashflows, lower borrowing cost and lower profitability of Financial distress.
(b) Since the projects are divisible and assuming a simple period capital rationing, then use profitability index to allocate the Sh. 40m. If variable costs are 40% of sales, contribution margin is 60% a hence in absence of taxes, cashflows will be determined as follows.