International Investment: Importance of Investment Appraisal - Case Study Example

1. Aim and Objectives: In order to remain competitive and expand, businesses regularly choose to make investments internationally. It is essential then, that the management makes informed decisions when considering every investment proposal, as these decisions may not be easily reversible, involve large sums of money and are generally based on predictions (Bott, 2008). Hence, it is important that managers are aware of the consequences of every investment (Duncan Williamson, 2003). While considering investing in a project, the company will normally have a number of proposals to choose from. In the case of Smith International Group of Hotels, there are two proposals involving International investments – a hotel in London and a Health club in Paris. This report focuses on the various vehicles used for investment appraisal and their relative merits and demerits. Then these techniques are applied to the two proposals and the final decision regarding the choice of the project is made. The report also aims at discussing the various hedging strategies that can be used by the company to keep its investments safe. 2. Investment Appraisal As the financial consultant of the company the main aim is to find out which of the investments in the company is feasible, and viable. Before moving into the discussing the two options available for Smith International Hotel Group, it is important to understand a few basic details of the techniques used to appraise a project, i.e. the investment appraisal techniques. Investment Appraisal is defined as; “Evaluation of the attractiveness of an investment proposal, using methods such as internal rate of return (IRR), net present value (NPV), or payback period (PP). Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training” (Gotze et al, 2009, p24). There are a number of investment appraisal techniques available to analyze the projects. They include Payback period, Net Present Value, Profitability Index and Internal Rate of Return. The net present value, profitability index and the internal rate of return take the time value of money into account whereas the payback period does not consider the time factor. In order to account for the time value of money, the cash flows are discounted using the company’s cost of capital. The various investment appraisal techniques are described in the following section. 2.1 Payback Period Payback period, as the name indicates, computes the time taken for the project to generate cash flows to break even. In other words, it is the number of years that will be taken by the project to pay back the initial investment to the company (Lumby& Jones, 1999). It is the simplest of all the investment appraisal techniques and is calculated as: Payback Period = Number of years taken for Ct to be equal to initial investment Where Ct = Sum of cash flows The project with the lowest payback period is preferred over others. 2.2 Net Present Value (NPV) As discussed earlier, Net Present Value utilizes the discounted cash flows and computes the total worth of the project to the company. It is a widely accepted method, as it applies discounted cash flows and is simple to compute once the cost of capital is available. The cash flow estimates for the life of the project are discounted to present values and the net sum of the cash flows (including any outflows) provides the Net Present Value of the project (Lumby& Jones, 1999). It indicates that the project will increase the worth of the company by this value. It is computed as follows: PV of future cash flows = (t=1ton) Ct/(1+r)t where Ct is the cash flow generated in period t, r is the discount rate used and n is the number of years. The projects with positive NPV are accepted and others are rejected. In the case of mutually exclusive projects, the one with the higher NPV is selected. 2.3 Profitability Index (PI) The Net Present value (NPV) is an effective method in taking decisions. However, in the case of projects with positive NPV, the method indicates that the one with the higher NPV should be selected. It does not focus on the amount of investment required for each project and on the profitability (Gotze, 2009). The profitability index (PI) aims to standardize the NPV calculations against differing initial investments and profits of different projects. It is calculated using the formula, Profitability Index (PI) = Present Value of Net Cash Flows / Initial Investment The rule of the thumb is to select the project with the higher Profitability Index. 2.4 Internal Rate of Return (IRR) The cost of capital in most cases is volatile and changes during the life of the project. This can affect the returns and the Net Present Value computed during the project start up. The internal rate of return is used to compute a maximum discount rate that can be applied to the project without incurred any losses and gives an indication of the margin of safety of the project. This method works on trial and error basis. Initially the NPV for an assumed rate is determined and based on this value; another rate is selected so that the new NPV approaches closer to zero ((Lumby& Jones, 1999). Based on these two values, the IRR can be computed using the cross-multiplication rule. The project with the IRR higher than the cost of capital is preferred. In the case of multiple projects qualifying the criteria, the project with the highest IRR is selected (Dayananda, Irons & Harrison, 2002). These are the various investment appraisal vehicles that will be applied by the finance teams to the two proposals available to Smith International Group of Hotels. 3. Calculation of Investment Appraisal Metrics The two proposals are analyzed and the above methods are applied to compute the investment appraisal metrics discussed in the above sections. 3.1 Proposal One – Hotel in London: The first proposal is to build a hotel in London which involves an initial construction cost of £15 million. Based on the estimated variable and fixed costs and the occupancy rates for the first 5 years of operations, the cash flows in the local currency (Pounds Sterling) are calculated. The value of the hotel at the end of 2015 is estimated to be £12 million. For this analysis, it is assumed that the hotel is sold in 2015 for this amount. The cash flows for the project are computed (see Appendix 1) as follows: Cash Flow Estimate (in £ from Hotel in London) Year Year1 Year2 Year3 Year4 Year5 Year6 Cash Flow (15,000,000) 504,000 5,322,000 3,132,000 2,256,000 13,380,000 These cash flows are nominal and hence have to be adjusted to reflect the effects of inflation in the UK to arrive at the real cash flows in Pounds Sterling. As the company accounts and reports the transactions in dollars, it is necessary to convert these cash flows into dollars. The constant exchange rate is estimated to be $1.6723/£. However this rate is not applicable for the five years, as the inflation rates in the two countries (United States and the United Kingdom) are different. This will lead to a difference in the purchasing power of money in the two countries. In order to account for this purchasing power parity, the exchange rate is adjusted to reflect this parity. The exchange rate calculations are attached in Appendix 2. The cash flows in dollars are obtained based on this exchange rate. Year Year1 Year2 Year3 Year4 Year5 Year6 Cash Flow (£) £(15,000,000) £504,000 £5,322,000 £3,132,000 £2,256,000 £13,380,000 Inflation 1 .015 (1.015)2 (1.015)3 (1.015)4 (1.015)5 (1.015)6 Money Cash Flow £(15,225,000) £519,233 £5,565,100 £3,324,191 £2,430,353 £14,630,271 Exchange Rate 1.7110 1.7506 1.7912 1.8326 1.8751 1.9185 Cash Flow ($) $(26,050,253) $908,987 $9,968,012 $6,092,029 $4,557,071 $28,067,860 Payback Period: From the above cash flows, the payback period is calculated. Initial Investment on 31 December 2010 = $26,050,253 The payback period is computed in Appendix 4 of the report. The payback period has been found to be 4 years and 1.93 months from the time of initial investment. Net Present Value: The net present value is computed using the company’s cost of capital (10%) as follows: Year Cash Flow ($) Discount CF * Discount Year1 $(26,050,253) (1/1.10) $(23,682,048) Year2 $908,987 (1/1.10)2 $751,229 Year3 $9,968,012 (1/1.10)3 $7,489,115 Year4 $6,092,029 (1/1.10)4 $4,160,938 Year5 $4,557,071 (1/1.10)5 $2,829,583 Year6 $28,067,860 (1/1.10)6 $15,843,575 Net Present Value $7,392,391 The hotel in London will increase the net worth of the company by $7,392,391. Profitability Index: The present values of the cash inflows are obtained from the NPV calculations and are found to be $31,074,440. The initial investment is $23,682,048. PI = $31,074,440 /$23,682,048 = 1.31 Internal Rate of Return: The IRR is identified based on a trial and error method. NPVs at various discount rates are identified. The calculations of IRR are presented in Appendix 5. The IRR is found to be 18.66%. 3.2 Proposal Two – Health Club and Spa in Paris: This is the proposal to build a health club and spa in Paris, France. Here the construction costs amount to €20 million. The estimates of occupancy rates and the expenses are used to arrive at the cash flows resulting in the five years of operations in Euros. The estimated worth of the health club at the end of 2015 is €15 million. It is assumed that the hotel will be sold at this rate in 2015 and included in the cash flow calculations (see Appendix 3). Cash Flow Estimate (in € from Health Club in Paris) Year Year1 Year2 Year3 Year4 Year5 Year6 Cash Flow (20,000,000)€ 2,471,250€ 3,748,750€ 3,110,000€ 3,110,000€ 16,832,500€ The estimated exchange rate for the conversion of Euros to dollars is $1.4744/€. The purchasing power parity theorem is applied to account for the difference in the buying power of the two currencies and the exchange rates are computed as shown in Appendix 4. The cash flows in dollars are computed as follows: Year Year1 Year2 Year3 Year4 Year5 Year6 Cash Flow (€) (20,000,000)€ 2,471,250€ 3,748,750€ 3,110,000€ 3,110,000€ 16,832,500€ Inflation 1.028 (1.028)2 (1.028)3 (1.028)4 (1.028)5 (1.028)6 Money Cash Flow (20,560,000)€ 2,611,577€ 4,072,544€ 3,473,224€ 3,570,475€ 19,865,857€ Exchange Rate 1.4895 1.5047 1.5200 1.5356 1.5513 1.5671 Cash Flow ($) $(30,623,288) $3,929,570 $6,190,437 $5,333,370 $5,538,705 $31,131,708 Payback Period: From the above cash flows, the payback period is calculated. Initial Investment on 31 December 2010 = $30,623,288 The payback period is computed in Appendix 4 of the report. The payback period is found to be 4years and 3.71months from the time of initial investment. Net Present Value: The net present value is computed using the company’s cost of capital (10%) as follows: Year Cash Flow ($) Discount CF * Discount Year1 $(30,623,288) (1/1.10) $(27,839,353) Year2 $3,929,570 (1/1.10)2 $3,247,578 Year3 $6,190,437 (1/1.10)3 $4,650,967 Year4 $5,333,370 (1/1.10)4 $3,642,763 Year5 $5,538,705 (1/1.10)5 $3,439,100 Year6 $31,131,708 (1/1.10)6 $17,573,038 Net Present Value $4,714,094 The hotel in London will increase the net worth of the company by $4,714,094. Profitability Index: The present values of the cash inflows are obtained from the NPV calculations and are found to be $32,553,446. The initial investment is $27,839,353. PI = $32,553,446 /$27,839,353 = 1.17 Internal Rate of Return: The IRR is identified based on a trial and error method. NPVs at various discount rates are identified. The calculations of IRR are presented in Appendix 5. The IRR is found to be 15.24%. 4. Relative Merits and Demerits 4.1 Payback Period: The payback period is the simplest of all methods. This method can be quickly applied to simple projects with short life span. However the cash flows are not discounted to account for the time value of money (Lumby& Jones, 1999). Hence the actual results (in terms of value of the company) might be completely different than that estimated by the payback period. Also, this method ignores all the cash flows arising after the payback period and hence does not take into account the total profits obtainable from a project (Dayananda, Irons & Harrison, 2002). 4.2 Net Present Value: This is the most commonly used appraisal method and is simple to apply. It accounts for the time value of money and also includes all the possible cash flows arising from a project. However this method does not include the profitability of a project, i.e., NPV might reject a project which has a lower investment and higher profitability. In other words, NPV does not offer comparison on the initial outlay and the income arising from that outlay (Gotze, 2009). 4.3 Profitability Index: This method helps overcome the demerit of NPV and accounts for profitability comparison. As present value cash flows are used in this method, the effect of time on the value of money is included. However this method does not indicate any margin of safety or sensitivity of the projects involved (Bott, 2008). It can be misleading at times when the company has higher capital resources available to invest in projects. 4.4 Internal Rate of Return: Apart from utilizing the discounted cash flows, this method reflects the risks involved in the projects. When two or more projects have very high values, the IRR method does not help in the final decision (Dayananda, Irons & Harrison, 2002). The main demerit of IRR is that one project can have multiple IRRs and this method cannot be applied in least cost situations (Bott, 2008). Moreover the calculations can be complicated as they are trial and error based. 5. Recommendations Based on the investment appraisal conducted for the two proposals, the results are tabulated as follows: Method Proposal 1 Proposal 2 Payback Period 4years 2months 4years 4months Net Present Value $7,392,391 $4,714,094 Profitability Index  1.31 1.17 Internal Rate of Return  18.66% 15.42%  It is evident from the above results that all the methods used in the analysis recommend that proposal one has to be accepted. Hence Smith International Group of Hotels has to take up the project and build a hotel in London. 6. Hedging Techniques: International investments involve a number of benefits as well as risks. Companies require taking into account two main risks which include the return for investments and the currency involved in the transaction. Of these the issue of the return for investments can be assessed using the Capital budgeting and investment appraisal methods. However it is important for the companies to address the risks and issues that relate to the changes in the foreign currency (Melvin, 2003). The process of addressing this risk and reducing the risks is referred to as Hedging. The process involves the company to make investments which can be used to compensate for the possible losses that might have occurred or are expected to occur. The underlying objective is to help reduce the risks and to limit the possibility of any financial losses. Owing to the fact that the foreign exchange markets are highly volatile and are also faced with high levels of price movements, this is an important process that requires to be followed. In theory, all investment appraisal calculations tend to use constant currency conversion rates, however in practice this is different as there can be a number of changes in the exchange rates and there are high chances for the financial figures to be wrongly forecasted (Melvin, 2003). This can also lead to unexpected losses or gains of the projects. Hence to ensure the accuracy of the financial figures, it is necessary to reduce the risks by hedging (Eiteman, et.al, 2009). Over the years a number of techniques have been developed and that can be used by Smith International Hotel Group. A few of the techniques that can be used includes the forwards contracts. These can prove to be most effective and efficient for the Smith International Hotel and are simple and straightforward (Eiteman, et.al, 2009). The forward contracts can be used by the company to enter into contracts and can sell at fixed rate in the future on a certain date. It is essential that the company enters into these contracts when the price is most favourable and this will help ensure that the returns are profitable on the future date as well (Madura, 2009). This should be used by Smith Group for hedging. The second technique that can be used by the company is Foreign Currency Option. These are similar to the forward contracts with a slight variation. In these types of contracts neither the seller nor the buyers are obligated to execute the contract. This will prove to be very helpful for Smith Group and can be used periodically. The company should however not use this technique alone, as there are chances that the buyer might not execute the contract if it is not favourable. In the case of Smith Group, a combination of the two techniques, i.e. forwards contracts and foreign currency options will prove to be most useful and effective. Another very effective technique that can be used by Smith Group is the foreign currency swaps. These entail swapping both principal and interest between the parties with the cash flows in one direction being a different currency than those in the opposite direction. These also allow the exchange of fixed and floating rate interest for the period of the contract (Hill, 2008). This is an effective technique and helps is hedging the risks to a great extent. 7. Summary: Smith Group currently requires adopting an effective hedging strategy and needs to make a good mix of the techniques. It is imperative that Smith Group creates an effective mix of the three techniques and adopts the forward contracts as a major hedging portfolio (Copeland, 2008). The foreign currency swaps can form a relatively lower part of the portfolio and can be implemented sporadically. The main aim of the company while deciding the portfolio should be to maintain liquidity (Bekaert, 2008). Bibliography Bott, F., 2008, ‘Professional Issues in Information Technology: Chapter 8 – Investment Appraisal’, Accessed on 27 March, 2010, Retrieved from http://www.bcs.org/upload/pdf/profissuessamplechapter.pdf Duncan Williamson, 2003, Capital Budgeting: The Key Numerical Techniques, 12 October 2001 revised 8 May 2003, Accessed on 27 March 2010, Retrieved from http://www.duncanwil.co.uk/invapp.html Goetz, U & Northcott , D & Schuster, P (2009) Investment Appraisal: Methods and Models. Springer Berlin Heidelberg, pp. 29 – 122 Lumby, S & Jones, C (1999). Investment appraisal & financial decisions. 6th ed. London: International Thomson Business Press. Pp 76-150 Dayananda, D Irons, R, Harrison, S. Herbohn, J & Rowland, P. (2002) Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. Pp. 90 - 114 Melvin, M (2003). International Money and Finance.7th ed. Addison Wesley .Pp. 70 - 84 Eiteman, D Stonehill, I & Moffett, M (2009) Multinational Business Finance. 12th ed. Addison Wesley. Madura, J (2009). International Financial Management. 10th ed. South-Western College Pub.Pp.103-152 Hill, C (2009). International Business: Competing in the Global Marketplace. 7th ed. McGraw-Hill Higher Education -A. Copeland , L (2008). Exchange Rates and International Finance. 5th ed. Addison Wesley. Pp. 239 - 250 Bekaert, G& Hodrick, R.J. (2008). International Financial Management . Prentice Hall. Appendix – 1 Cash Flow Estimate for Proposal One – Hotel in London: Cash Flow Estimate (in £ from Hotel in London) Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Occupancy Rate   40% 95% 70% 60% 50% Rooms Occupied   87,600 208,050 153,300 131,400 109,500 Total Revenue   £7,008,000 £16,644,000 £12,264,000 £10,512,000 £8,760,000 Variable expenses   £3,504,000 £8,322,000 £6,132,000 £5,256,000 £4,380,000 Fixed expenses   £3,000,000 £3,000,000 £3,000,000 £3,000,000 £3,000,000 Others £(15,000,000)         £12,000,000 Cash Flow £(15,000,000) £504,000 £5,322,000 £3,132,000 £2,256,000 £13,380,000 Appendix – 2 Exchange Rate from Pounds Sterling to Dollars: Year 0: 1.6723 Year 1: 1.6723 * (1.0385) / (1.0150) = 1.7110 Year 2: 1.6723 * (1.0385)2 / (1.0150)2 = 1.7506 Year 3: 1.6723 * (1.0385)3 / (1.0150)3 = 1.7912 Year 4: 1.6723 * (1.0385)4 / (1.0150)4 = 1.8326 Year 5: 1.6723 * (1.0385)5 / (1.0150)5 = 1.8751 Year 6: 1.6723 * (1.0385)6 / (1.0150)6 = 1.9185 Appendix – 3 Cash Flow Estimate for Proposal Two – Health Club in Paris: Cash Flow Estimate (in € from Health Club in Paris) Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Occupancy Rate   70% 90% 80% 80% 60% Rooms Occupied   127,750 164,250 146,000 146,000 109,500 Total Revenue   8,942,500€ 11,497,500€ 10,220,000€ 10,220,000€ 7,665,000€ Variable expenses   4,471,250€ 5,748,750€ 5,110,000€ 5,110,000€ 3,832,500€ Fixed expenses   2,000,000€ 2,000,000€ 2,000,000€ 2,000,000€ 2,000,000€ Others (20,000,000)€         15,000,000€ Cash Flow (20,000,000)€ 2,471,250€ 3,748,750€ 3,110,000€ 3,110,000€ 16,832,500€ Appendix – 4 Exchange Rate from Euros to Dollars: Year 0: 1.4744 Year 1: 1. 4744 * (1.0385) / (1.0280) = 1.4895 Year 2: 1. 4744 * (1.0385)2 / (1.0280)2 = 1.5047 Year 3: 1. 4744 * (1.0385)3 / (1.0280)3 = 1.5200 Year 4: 1. 4744 * (1.0385)4 / (1.0280)4 = 1.5356 Year 5: 1. 4744 * (1.0385)5 / (1.0280)5 = 1.5513 Year 6: 1. 4744 * (1.0385)6 / (1.0280)6 = 1.5671 Appendix – 4 Payback Period: 1. Proposal One: Year Cash Flow ($) Cumulative CF Year1 $908,987 $908,987 Year2 $9,968,012 $10,876,999 Year3 $6,092,029 $16,969,028 Year4 $4,557,071 $21,526,099 Year5 $28,067,860 $49,593,960 In year 5, $4,524,154 ($26,050,253-$21,526,099) is required to get the initial investment. $4,524,154 /$28,067,860 = 0.16*12 = 1.93 months 2. Proposal Two: Year Cash Flow ($) Cumulative CF Year1 $3,929,570 $3,929,570 Year2 $6,190,437 $10,120,007 Year3 $5,333,370 $15,453,377 Year4 $5,538,705 $20,992,081 Year5 $31,131,708 $52,123,790 In year 5, $9,631,207($30,623,288-$20,992,081) is required to get the initial investment. $9,631,207/$31,131,708 = 0.31*12 = 3.71 months Appendix – 5 Internal Rate of Return: 1. Proposal One: NPV at 10% = $7,392,391 NPV at 20% = $(1,139,624) Applying interpolation, IRR = 10+ [$7,392,391/($7,392,391+$1,139,624)]*(20–10) = 18.66% 2. Proposal Two: NPV at 10% = $4,714,094 NPV at 20% = $(3,984,249) Applying interpolation, IRR = 10+ [$4,714,094/($4,714,094+$3,984,249)]*(20–10) = 15.42% Read More