Concept of Capital Rationing and Real Options - Assignment Example

ADVANCED FINANCIAL MANAGEMENT ADVANCED FINANCIAL MANAGEMENT Introduction Task using the academic underpinning, describe the concepts of Real Options and Capital Concept of capital rationing and real Options Capital rationing is the process of placing restrictions on the amount of new projects or investments that are undertaken by the company. That can be accomplished by putting a higher cost of capital investment consideration or establishing a ceiling on the particular sections of the budget. Firms may wish to implement capital rationing in certain situations where previous returns of investment were less than expected (McLean, 2003). For instance, suppose a corporation has a cost of capital of 10%, however the firm has undertaken very many projects, some of which are which are incomplete (Zelman, 2003). That will cause the actual return on investment of the company to drop below the level of 10%. Due to the fact, the management will decide to place the cap on the number of new projects by raising the capital cost for the new projects up to 15%. Commencing with the new projects, it would give the company more resources and time to finish the existing projects (Mr. Jamie Rogers, 2013). On the other hand, a real option is the right but not the obligation to take various objectives in business on the capital investment project. For instance, the chance to invest in the expansion of a company’s factory or otherwise to sell the plant, is a put or real option respectively (Ehrhardt, 2002). In reality, the real options are always distinguished from conventional financial options in a manner that they are not always traded as securities. In addition, they do not unusually entail decisions on an asset that is underlying which is sold on a financial guarantee (Kaplan, Atkinson and Morris, 1998). Task 2 Look into the extent of adoption of the tools and explain their impact on the decision-making process in the firm. You must check the relative validity of NPV and Real Options while appraising risks and uncertainty (Chandra, 1997). The adoption of capital rationing and real options tools has a very high impact on the decision-making process in a company. For instance, looking at the example below; (Arnold, 2008). Net Present Value (NPV) is usually a formula that is used to demonstrate the present value of the investment by the discounted total of all cash flows provided from the project. The formula for the discounted sum of all cash flows can be shown as (Campbell, and MacKinlay, 1997). When a firm or investor takes on a project or investment, it is essential to determine an estimate of how profitable the investment or project will be (Swansburg, 1997). In the formula, the -C0 is the initial investment, which is a negative cash flow demonstrating that cash will be going out as opposed to coming in (Kaushal, 2010). Considering that the money going out is deducted from the discounted addition of cash flows coming in, the net present value would be required to be positive. The positive Net Present value is an indication that the investment is valuable (Gilson, 1989). To give an example of Net Present Value, consider an individual company. Finding the company, the task is determining whether they should invest in a new project. The company will expect to spend $500,000 for the development of the new product. The firm anticipates that the first-year cash flow will be $200,000; the cash flow of the second year will be $300,000, and the third-year cash flow to be calculated $200,000. The expected return of 10% will be used as the discount rate (Ang, 1991). The below table provides cash flow of each year and the present value of every money flow. Year Cash Flow Present value 0 - $600,000 -$600,000 1 $400,000 $131,818.18 2 $200,000 $257,933.88 3 $100,000 $180,262.96 Net Present Value = $70,015.02 The NPV, for example, may be demonstrated in the formula (Ogden, Jen and Connor, 2003). In calculating the NPV for each machine and deciding which machine should be invested in? As calculated previously, The Company’s cost of capital is 8.4%. (Morck, Shleifer, and Vishny, 1988). Answer: NPVA = -6,000 + 200 + 2,000 + 2,000 + 2,500 + 2,500 + 2,000 = $147 (1.092)1 (1.092)2 (1.092)3 (1.092)4 (1.092)5 (1.092)6 NPVB = -6,000 + 200 + 2,500 + 2,500 + 2,500 + 2,500 + 2,500 = $5,929 (1.092)1 (1.092)2 (1.092)3 (1.092)4 (1.092)5 (1.092)6 (Berliner and Brimson,1988). When trying to consider mutually exclusive projects and NPV alone, remember that the decision rule is to invest in the project with the greatest NPV (Emanuelson, 2013). As the Machine has the highest NPV, the company should invest in the Machine (Yermack, 1996). Task 3 Using the information below, it assesses the potential value that is included to Richie’s Plc. It was obtained from the Capital Investment Project that proposed utilizing the following finance modelling techniques (Berman, Wicks, Kotha and Jones, 1999). Cash inflow Growth Rate: 5% Base-case Unit sales 20,000 Price per unit $300 Variable cost per unit (200) Cash fixed costs per year (500,000) Depreciation expense $360,000 Initial cost of equipment $2,000,000 Project and equipment life 5 years Salvage value of equipment $200,000 Working capital requirement $300,000 Depreciation method Straight line Required rate of return 12% Tax rate 30% Variable cost Increase by 5.5% every year Standard Deviation: 1% Discount rate: 20% Time: 5 years.. (Deventer, Imai and Mesler, 2013). More so, estimates for selling price, unit sales, variable cost per unit and fixed cost operating expenses for the base situation may be determined. Some of the base positions are worst situation and best situation as demonstrated in Table 2 (Paterson and Telyukov, 2014). Table 2; five year’s case scenario Base-case Worst-case Best-case Unit sales 20,000 15,000 25,000 Price per unit $300 $250 $330 Variable cost per unit (200) (210) (180) Cash fixed costs per year (500,000) (450,000) (350,000) Depreciation expense $360,000 $360,000 $360,000 (Skerlep and Tandberg, 2009). Year             Cash Flow                 Present Value  0                 -$500,000                 -$500,000  1                  $200,000                   $181,818.18  2                  $300,000                   $247,933.88  3                  $200,000                   $150,262.96 Net Present Value = $80,015.02 (Bhatt, 2008). The net present value of this example can be demonstrated in the formula NPV=$ 80,015.02 (Brigham and Ehrhardt, 2014). 2) Monte Carlo Simulation Mean Npv Standard deviation Npv 282.87 250 282.87 250 (Finkler, Kovner and Jones, 2007). The mean of the NPV shows that the financial performance of the company is at the peak. It also indicates that the firm has an excellent business platform that is an advantage to the company (Zelman, 2003). The standard deviation seems to be constant which is an indication that the company is doing well in terms of financial performance. The maximum value is 282.87 which is also the minimum value (Khan and Jain, 2007). Project A Project B Project C Project D Outlay Year 0 (500,000) (400,000) (120,000) (1000,000) Expected Inflow Year 1 350,000 250,000 90,000 900,000 (Quinn, 2007). Cash inflow Growth Rate: 5% Standard Deviation: 1% Discount rate: 20% Time: 5 years 3) Sensitivity analysis Using the below table the sensitivity analysis can be adequately determined Base-case Unit sales 20,000 Price per unit $300 Variable cost per unit (200) Cash fixed costs per year (500,000) Depreciation expense $360,000 Initial cost of equipment $2,000,000 Project and equipment life 5 years Salvage value of equipment $200,000 Working capital requirement $300,000 Depreciation method Straight line Required rate of return 12% Tax rate 30% Variable cost Increase by 5.5% every year (Barrow, 2011). In addition, anticipations for the unit sales, selling price, variable cost per unit and fixed cash operating expenses for the worst-case, base-case and best-case are described in Table 2 (Horne and Wachowicz, 2008). Table 2: Five years case scenarios Base-case Worst-case Best-case Unit sales 20,000 15,000 25,000 Price per unit $300 $250 $330 Variable cost per unit (200) (210) (180) Cash fixed costs per year (500,000) (450,000) (350,000) Depreciation expense $360,000 $360,000 $360,000 When an individual is trying, evaluate a decision node; write down the cost of each option along each decision line (Brown, 1992). Then deduct the cost from the results value that you have already calculated. This will provide you a value that represents the benefit of that decision (DeAngelo and Masulis, 1980). Note that amounts already spent will not count for the analysis – these costs that sunk and (despite emotional arguments) must not be factored into the decision (Brigham and Houston, 2012).When an individual has calculated these decision benefits, select the option that has the biggest interest, and take that as the decision that is made. That is the value of that decision node (Guthrie, 2005). (Lasher, 2014). Net Present Value (NPV) is the formula used to demonstrate the present value of an investment by the discounted total of all cash flows provided from the project. The method for the discounted amount of all cash flows can be shown as below (Marsh, 2012). Year             Cash Flow                 Present Value  0                 -$500,000                 -$500,000  1                  $200,000                   $181,818.18  2                  $300,000                   $247,933.88  3                  $200,000                   $150,262.96 Net Present Value = $80,015.02 (Taylor and Pinczuk, 2006). The net present value of this example can be demonstrated in the formula (Venkatasivakumar, 2011). 4) Decision tree (Venkatasivakumar, 2011). The project will be worth investing since the NPV will be & 80,015.02. In addition since the project manager wants to go on with the chosen project using invisible and independent criteria, he will have to use a decision tree. The reason is because the project manager will be in a better position to know if he will have to wait for two or three years or just invest immediately. According to the decision tree above it is clear that the project is worth investing and the project manager should start the project immediately without wasting much time. If the project manager waits for the two to three years he will lose a lot of profits that could be yielded by the project. Therefore it will be wise to start the project immediately (Venkatasivakumar, 2011). Conclusion Capital rationing is the process of placing restrictions on the amount of new projects or investments that are undertaken by the company. That can be accomplished by putting a higher cost of capital investment consideration or establishing a ceiling on the particular sections of the budget (Shen and Huang, 2011). Firms may wish to implement capital rationing in certain situations where previous returns of investment were less than expected. For instance, suppose a corporation has a cost of capital of 10%. However, the firm has undertaken very many projects, some of which are which are incomplete. In reality, the real options are always distinguished from conventional financial options in a manner that they are not always traded as securities. In addition, they do not usually entail decisions on an asset that is underlying which is sold on a financial guarantee (Wildeman and Jogo, 2012). When a firm or investor takes on a project or investment, it is essential to determine an estimate of how profitable the investment or project will be. In the formula, the -C0 is the initial investment, which is a negative cash flow demonstrating that cash will be going out as opposed to coming in (Kapil, 2011). The mean of the NPV shows that the financial performance of the company is at the peak. It also indicates that the firm has an excellent business platform that is an advantage to the enterprise. The standard deviation seems to be constant which is an indication that the company is doing well in terms of financial performance (Cohen and Cesta, 2005). When an individual is trying, evaluate a decision node, note down the cost of every option along each line of choice. Then deduct the cost from the results value that you have already calculated (Jansen and Stauffacher, 2010). That will provide an individual a value that represents the benefit of that decision. Therefore, the company in question should utilize the mean of the NPV to demonstrate the financial position. The firm should also use the standard deviation so that it can be aware of how profitable the investment or project will be. The products manufactured utilizing the new technology is expected to be sold at a price of $300 per unit and price enhance rate is 1.5% per year. 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