Investment Appraisal Under Uncertainty - Assignment Example

Investment Appraisal under Uncertainty Memo Task Force Members Frank Stewart, Senior Manager 5 June, Next Meeting Agenda Member selection Bilal (Construction Manager), Ahmed (Finance Manager), David (Project Manager) and Frank (Site Manager). Bilal has vast experience in the construction industry whereas Ahmed has been serving in the financial sector for last 10 years. Similarly, David has project-related experience and Frank has over sighted more than 50 projects in many fields. You have been selected to participate in the next meeting for discussing the issues relating to the new investment project. In this meeting, all other task members will also participate and they all are required to actively participate in the meeting and provide personal understanding about the new investment project. And your selection is mainly based on your academic record and related work experience. Project summary The project’s overall investment outlay would be $ 10,000,000. In this project, the focus would be to generate the expected inflows by using the NPV approach. However, given the magnitude of the investment in the project, it is highly essential that a comprehensive feasibility report would be drafted in which all technical, technological, market and other regulatory measures would also be considered. The project is a construction of mega 10 storey building in the centre of the city in which more than 60 apartments will be constructed over the period of 5 years. As the company deals in construction projects, this project will generate substantial amount of inflows for the company. Project potential It is expected that the project’s payback period will be six years besides generating a positive NPV of $ 1,750,000. Based on this investment outlook, on the face of the project, it looks worthwhile investment opportunity. However, it is still relevant to consider other factors. B1. Net Present value Investment 0 1 2 3 4 5 6 7 Initial Outlay -10,000 2,000 2,600 1,245 2,100 1,400 1,850 1,000                 PV   0.9091 0.8264 0.7513 0.683 0.6209 0.5645                     8,250.09 1818.2 2148.64 935.3685 1434.3 869.26 1044.325                     NPV -1,749.91               Payback period Investment 0 1 2 3 4 5 6 -10,000 1,000 1,500 1,500 2,000 1,200 1,800 1,000               -10,000 9,000 7,500 6,000 4,000 2,800 1,000 0 Five Reluctance Reasons Technological impediment It is possible that the proposed project with positive NPV may not be useful from technological point of view. As the frequency of technology has become unpredictable in the recent years, the project may not be able to generate returns after three years because the latest form of technology relating to one which would be used in the project has become obsolete and customers and trends would reflect that the future expected inflows may not become probable. Systematic risk It may be possible that the government would impose additional taxes and other regulatory checks relating to the products that would be produced through the project. Recently, one simple example is the imposition of carbon tax in Australia and other developed countries are also considering enforcing the similar measure. Consequently, the projects expected inflows may not be appropriately realistic. Future estimations It is expected that the project will provide a steady stream of inflows which will be used for financing the future projects. This project has a strong potential for generating the inflows as the project is centrally located in the city where business activities take place throughout the year. Demand decrease It is possible that the products which would be generated by the project may no longer be demanded by the customers. This is one of the forms of market uncertainty in which customers change their taste and products as they are influenced by a range of different economic and social factors. Increased business cost It is possible that the business cost may not remain the same but experience a sudden rise which would directly affect the cash inflows. Consequently, the increased business cost would decrease the financial attractiveness of the project. Describe the strengths and weaknesses of the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period (PP) investment appraisal techniques to evaluate investments projects in contexts of high market, technical and technological uncertainty. Net Present Value (NPV): Strengths and weaknesses NPV is defined as a present value of cash flows minus initial project cost; it is obtained through deducting a project’s initial investment from the present value of the associated cash inflows at the pre-determined cost of capital (Khan and Jain, 2010). Strengths The NPV method provides an objective measure for decision making that increases the chances of shareholders’ wealth (Baker and Powell, 2005). The objective criterion for decision making means using those financial management standards which are primarily based on the standards of objectivity. The NPV method takes into account time value of money besides including all relevant cash flows over the project life (Baker and Powell, 2005). When all the relevant cash flows are taking into account within the project life, it enables decision makers to consider the effects of cash flows. Additionally, the use of time value of money approach again takes into account the future changes and fluctuations of money are also accounted for in this approach. The NPV method generates an unambiguous selection or rejection benchmark (Baker and Power, 2005). Since the NPV method uses the standard of positive and negative NPV, firms become in a position to determine and decide any decision, primarily relying on the positive or negative NPV. Weaknesses The concept of NPV is not easy to understand even for many senior managers (Baker and Powell, 2005). This concept purely uses the fundamental theories of financial management and particularly the concepts within capital budgeting. Normally, it has been observed that many investment managers find it hard to understand NPV; consequently, they avoid using it for computing the future or expected cash flows of different projects. The NPV fails to highlight and provide a relative measure of profitability (Baker and Powell, 2005). For example, if a project with initial outlay of $ 3000 provides $1000 NPV and the same NPV is also generated for a $1 million project, managers would be interested to go with the first project but would be less interested to select the second project (i.e. $1 million) because the second project’s NPV is considerably smaller when this NPV figure is compared with the initial outlay of the project. Internal Rate of Return (IRR) The IRR investment method represents the discount rate setting the NPV of an investment to zero (Rohrich, 2007). In this regard, it is important to highlight that an investment opportunity is worth availing if its IRR is tantamount to or greater than the required level of investor (Quiry et al. 2011). Strengths The IRR represents profitability in the form of percentage reflecting the return on each dollar (Baker and Powell, 2005). By providing profitability in the shape of percentage, the IRR enables the investment managers to understand the profit in more real quantitative terms. By doing so, their comparative analysis would be much easier (Baker and Powell, 2005). The IRR employs time value of money and all cash flows (Baker and Powell, 2005). By using these two measures for computing the ultimate outcome, the IRR approach becomes a useful measure for the investment manager in a way that enables them to consider the overall outflows and inflows of an investment project. The IRR method is preferred to the NPV approach (Baker and Powell, 2005). This preference is mainly caused by the fact that the IRR highlights returns in the shape of percentage whereas the NPV approach represents the returns in dollar terms. Moreover, the percentage figure enables the investment managers to compare the IRR with their minimum expected or acceptable returns while making project-related investment decisions (Baker and Powell, 2005). Weaknesses The IRR approach produces a number of IRRs in case a project has unconventional cash flow patterns (Baker and Powell, 2005). In this situation, the availability of more than one IRR would not serve the purpose but the whole process would become meaningless (Baker and Powell, 2005). At the same time, the IRR approach is based an assumption that the firm has natural tendency for reinvestment of all project’s cash inflows at the project’s IRR over the project life and that assumption may not be realistic (Baker and Powell, 2005). For the mutually exclusive projects, the IRR method may lead to a vague selection or rejection decision making criterion particularly when it is compared with the approach of NPV (Baker and Powell, 2005). In other words, the NPV provides more reasonable and understandable measure for assessing and making selection or rejection criterion for a project particularly for both independent and mutually exclusively projects as well. Payback period This investment technique highlights time aspect of an investment opportunity. In this technique, an investment manager is given an opportunity to know that how much it will take to recover the initial outlay from the project investment; this depiction is reflected through number of years which will be consumed for recovering the original investment. In this regard, it is important to highlight that the payback period provides different decision making benchmarks for an independent and mutually exclusively projects. As a result, the investment manager must take into account different aspects of projects before deciding any project. Strengths Payback period approach has two major strengths: simple and easy to understand and an appropriate measure for risk and liquidity of a project (Baker and Powell, 2005). In other words, investment managers do not require hard financial management skills to learn for computing the payback period but simple mathematical methods would be sufficient for calculating payback period of project. Additionally, for screening even minor projects and their feasibility, the investment managers are not required a detailed and comprehensive analysis particularly when they are employing the payback period (Baker and Powell, 2005). Moreover, the shorter the payback period, the higher will be the liquidity as the project thrashes out cash inflows quickly for getting back the initial investment on the project (Baker and Powell, 2005). In other words, if the firms have greater liquidity, they will be in a position to use that amount for funding other projects and that would increase their financial capability. Weaknesses The payback period has three major limitations: unclear disposal point, failure to take into account time value of money and failure to consider all cash flows (Greer and Kolbe, 2003). The payback period does not directly specify the months in which certain amount of cash inflows would be generated by a project; instead of highlighting the accurate timing and accurate amount of cash inflows, the payback period is only limited to determine and highlight the number of years it would take for recovering the initial investment on the project. Similarly, the payback period is largely meaningless when it does not take into account the time value of money (Greer and Kolbe, 2003). It is a clear and accepted reality that the fluctuations in local and international currencies are common across the world; if an abnormal fluctuations take place in pound, the expected project inflows would not be able to justify the project decision because the foreign exchange changes have become so frequent that it is almost impossible to avoid their effects on any investment project. Moreover, the payback period also does not take into account all cash flows (Greer and Kolbe, 2003). It means the payback period approach ignores certain important cash flows which may be highly significant for the investment manager. In that condition, the ultimate objective of determining and selecting the most lucrative project would not be achieved through this payback period. in this regard, it is also important to mention that for taking a productive and attractive investment decision, it is highly important for an investment manager to fully know and understand risks and rewards attached with the projects under consideration; and the absence of any critical financial information would only increase chances of risk rather than providing more representative measure of rewards. c1. Define market, technical and technological uncertainty and introduce the real options theory and framework. Support your answer with the “best” academic literature available. “Market uncertainty refers to the ambiguity about the type and extent of customer needs that can be satisfied by a particular technology”(Drnovsek and Cirman, 2006:270). Technical uncertainty represents the amount of variation and unpredictability pertaining to methods and procedures for understanding solutions for any financial investment projects and other problems (Jensen et al., 2003). Technological uncertainty is related to the frequency of technological changes taking place within an industry (Czinkota et al., 2011). Technology has become an essential part of today’s financial and non-financial activities. Real options theory “Real options comprise a systematic approach and integrated solution using financial theory, economic analysis, management science, decision sciences, statistics, and econometric modelling in applying option theory in valuing real physical assets, as opposed to financial assets, in a dynamic and uncertain business environment where business decisions are flexible in the context of strategic capital investment decision making, valuing investment opportunities, and project capital expenditures” (Nembhard and Aktan, 2010:8). Based on this comprehensive definition of the real option theory, it can be deduced that this theory is not limited to the field of financial management but uses a variety of approaches and methods from other fields mentioned in the definition. In addition, Amran and Kulatilaka (2000) employ two different definitions for further elaboration of the concept of real options theory: first, they opine that the real options theory is nothing more than an extension of financial option-pricing models which are based on the real but non-financial assets; second, they express that it is a strategic way of thinking which enables managers developing and implementing strategic options in which today’s investments create tomorrow’s opportunities. c2. Discuss the advantages and disadvantages of the real options theory as compared to the above classical investment appraisal techniques. The real option theory is more comprehensive and challenging as well when it is compared with other classical investment appraisal techniques. For example, this approach uses a variety of methods and procedures whereas the classical investment appraisal techniques purely rely on the use and support of financial management. In addition, some of the classical investment appraisal techniques are simple and easy to understand (i.e. payback period) in contrast to the real option theory in which higher level of complexity is involved, making computation and understanding of this financial tool more difficult and challenging as well. In addition, the real option theory provides a range of options for a firm to choose any option as they want to; expansion, abandonment or timing option and strategic investment option are the real options. In other words, this method does not come with a single outcome as is provided by the payback period or NPV approach. The biggest advantage of the real options theory is that it has the ability to postpone making investment decision until additional but useful information is collected (Triantis, 2003). When this advantage is compared with other the classical investment tools, it can be highlighted that the classical investment methods do not offer such opportunity because their capability to analyze an investment opportunity is very limited and reliant on other underlying factors whereas the real options theory enables an investment manager to avoid making faster investment decision by delaying an investment decision. Moreover, the real options theory has capability to identify key uncertain sources, recognize them and provide a range of options to deal with the constraints (Triantis, 2003). This point clearly highlights that the real options has more capability for determining the inherent limitations or bottlenecks which hinder appropriate investment decision making, resulting in higher chances of obtaining inflows from the option. However, the real options theory is highly complex and challenging financial model. For a new investment manager and for lay man, the use and understanding of this model is very challenging because so much difficulty is involved that it is almost impossible to comprehend the practical application of this model promptly. Bibliography Baker, HK, & Powell, GE, (2005), Understanding Financial Management: A Practical Guide, Oxford: Blackwell Publishing Czinkota, MR, Kotabe, M, & Ronkainen, IA (eds) (2011), The Future of Global Business: A Reader, New York: Routledge Drnovesk, M, & Cirman, A, (2006) ‘The Framework for High-Tech Growth in a Small Opened Economy, in Prasnikar, J, Competitiveness, Social Responsibility and Economic Growth, New York: Nova Publishers, p. 270-278. Greer, GE, & Kolbe, PT, (2003), Investment Analysis for Real Estate Decisions, 5th edn, Chicago: Dearborn Real Estate Education Jensen, HS, Richter, LM, & Vendelo, MT, (eds) (2003), The Evolution of Scientific Knowledge, Glasgow: Edward Elgar Publishing Khan, MY, & Jain, PK, (2010), Management Accounting, 5th edn, New Delhi: Tata McGraw Hill Nembhard, HB, & Aktan, M (2010), Real Options in Engineering Design, Operations, and Management, New York: CRC Press Quiry, P, Vernimmen, P, Dallocchio, M, Le Fur, Y, & Salvi, A (2011), Corporate Finance: Theory and Practice, West Sussex: Wiley & Sons Rohrich, M, (2007), Fundamentals of Investment Appraisal: An Illustration Based on a Case Study, Munich: Oldenbourg Triantis, A, (2003), Real Options in Handbook of Modern Finance, ed. Logue, D, & Seward, J: New York: Research Institute of America, D1-D32 Read More