Application of Appraisal Methods in the Analysis of the South African Mines Project - Example

NAME: INSTITUTION: COURSE: DATE: APPLICATION OF APPRAISAL METHODS IN THE ANALYSIS OF THE SOUTH AFRICAN MINES PROJECT INTRODUCTION Capital budgeting also referred to as investment appraisal is a process mostly used by organizations in their long term projects in order to determine if the value of the returns are worth financing. The financing is done through the company capital organization. These include the company debt, shareholders equity both the ordinary and preference shareholders and the retained profits. It simply involves the incurrence of a huge amount of capital in order to gain from the project through the future cash flows into the firm (Wagnerite, 2010, pp. 345). This means there has to be a lot of the selecting and rejection of the projects through the application of an appraisal method adopted in the company. The main aim of use of appraisal methods in evaluating the viability of a project is to create value for the shareholder. The value of the shareholder is said to be maximized when the net cash inflows are greater than the cash outflows. There are various appraisal methods that are used in evaluating the viability of projects which include the three appraisal methods that we learned in this module. They include net present value (NPV), Monte Carlo simulation and the real option appraisal method. This paper will apply the appraisal methods that is the net present value and the real options analysis method in the analysis of the South African mines project in a mining company. South African mines project usually involves a lot of capital in terms of the equipment and labor. In addition to that the mining process takes place in a long period of time and therefore this paper will focus on the application of the net present value and the real options techniques in investment appraisal to analyze the South African mining project in a mining company Investment appraisals have two categories of techniques which include the discounted cash flow techniques and the non-discounted ones. The difference between these categories is that the discounted ones take into consideration the time value of money while the non-discounted do not (Moya, 2011 pp. 1207-1215) the net present value is one of the discounted cash flow techniques. The appraisal is referred to as the present value of cash inflows and the present value of the cash outflows. This means that the amount of cash outlay in a project is less than that of the future cash flows discounted to the present value. In order for one to convert the future cash inflows into the present value, there needs to be the presence of the required rate of return. In order for the NPV technique to work it should then involve estimated future cash flows of the project then you discount these cash inflows by using the required rate of return. The present value obtained should be subtracted from the initial cost used to invest for the project. In the NPV technique, a project is viable if its net present value is a positive number or at least the net present value should be equal to zero and thus acceptable. If the project has a net present value of less than zero then the project is not viable and thus the given project should be rejected (Wagnerite, 2010, pp. 356). Most organizations choose NPV as a technique in the appraisal as in some way it measures the profitability and takes into consideration the amount of risk. In addition to that, the NPV technique takes into consideration the time value of money and also the fact that in its calculation it uses all the cash flows in evaluating the projects, unlike other techniques. It has also some weaknesses in that it tends to increase if the rate of return is high and decrease when the rate of return decreases thus reducing its effectiveness in the NPV technique in measuring the feasibility of a that require a high level of technical expertise The real option technique as an appraisal method defines a real option as a right to something but not an obligation in terms of making any strategic financial decision. Basically, in investment appraisal, the real option technique narrows the real options in investment as the options to expand a business, make a product, contract, or leave the capital project being evaluated. (Haussmann, R, Rodrik, 2013, pp. 47-198).The real options method has the ability to make more changes after a project is accepted unlike the other techniques such as the net present value that fails to do so. Real option it enables the financial managers at a particular time they contemplate all the options available to them and evaluate them to either move ahead with them or reject them. It assumes that the worth of a real option reduces with time. This shows that the projects contain a certain element of insecurity especially in their aftermath and that insecurity will be clearer as time goes by (Jackson, J pp. 3865-3873). There are options in investment appraisal that have value in the example of the option to expand it involves a lot of capital and therefore the financial managers have to look at the various options they have and then make strategic decisions. Real option in appraising a project one is able to vary various options and therefore increasing the flexibility in terms of the decisions made. However, this method becomes difficult when determining the company whose shares are you to buy from thus only suitable for making of strategy I choose the South African mines project in a mining company this is because a mining project involves a huge outlay of cash outflow in order for it to cover all the expenses needed in the mining of mineral say gold for example. This selected project enables the on to apply both the net present value technique and also the real options. This will include the calculation of the net present value discounted to the present value and also how we can apply real options in the same case (Lefley, F. pp23- 38). I also choose this project because it is one of the projects that has been able to be successfully finished in South Africa and thus rendered this project as more appropriate. The assumptions that I considered in the coming up of the project cash flows include that firstly depending on the gold price and the discounting rate that the project is valued to an estimate of $50 million, then it generates a 7 million annual cash flow and the return rate of 10%. In this case, it is then assumed that the adjusted market capitalization is then estimated from the value of the mining company. Secondly, it assumes that the company net asset value is obtained from the average NPV's. It, therefore, said that once a financial manager makes an effort to compare the value of the mining company current project to the value of those estimated net present values of its projects a valuator can then evaluate whether the value is then going to be able to be obtained in the market. In addition to that, it is also very important to compare the value of the market to the NAV because it assists in the calculation of the discount at which the market is paying to a particular value estimate. The estimated revenue is that accumulates to $25 million annually. This revenue has been estimated on the basis in which there will be a constant growth rate throughout the ten years in which the project will take place (Schall, 2010, pp. 687). This is due to the previous estimates of the gold mining growth rate project. Gold as a metal is very demanding and its price is always high and therefore the growth rate is therefore estimated to have a constant increase. The fact that its use is very demanding in various industry such as the fashion industry in the making of Jewries and thus its rate of growth will increase constantly. The estimated revenue can also be explained through the Michael Porter's forces of competition The Michael Porter's forces of competition have five main components. It is said to be a tool that enables one to analyze competition within an industry and in this case, we will be looking at the Michael Porter's forces in helping us evaluate the estimation of revenue in this project. According to Michael is that a project is said to be unattractive if the projects five forces that affect it then causes the reduction in revenue of the project (Haussmann, R, Roderick, 2013 pp38- 68). IT continues to explain that those forces are those that are close to the mining company or those relating to the project and therefore they affect the capacity of the project to earn profit to the company. The five factors include; threats of new entrants. In this case, in this gold mining project, it is very difficult for new entrants to enter the market this is because it involves a huge amount of capital in the extraction of the gold. There is heavy equipment and machinery required for the extraction of gold, a high level of expertise that is required which very expensive to obtain and therefore new entrants into the market is very limited. The second important element of the Michael Porter's forces is that there can be threats to substitutes in the mining project of gold. This force is therefore important, as there are other metals that are available in actually doing the same function as that on that gold does and therefore it poses a threat in terms of the project. But in this case, the quality of gold is more certain and therefore in a selling the product there is no other product that has a substitute quality to that one of gold and therefore posing an advantage in terms of the profits and therefore leading to the estimated revenue of the project The third element of Michael porters is the bargaining power of the customers. In this case, the bargaining power of the customer is greatly reduced because the firms that undertake the mining of gold is limited therefore they cannot put pressure on the mining firm as few are in the market (Baurens, 2010, pp. 105-113). This is very advantageous this is because it the firm and not the customers that determine the final price and therefore the estimated revenue will therefore increase. The fourth element is the suppliers bargaining power; In this case the supplier which is the mining firm has the bargaining power. This is because there are few suppliers of god in the market because of its difficulty in the entry and therefore the suppliers are the ones to set up the price and thus there will be increased in revenue in this case. The fifth and last factor in the Michael Porter's forces is the industry rivalry. In this case, the industry rivalry does not apply since there are very few firms in the gold industry and thus the estimated revenue is likely to remain as high as possible. The real options analysis as we said earlier the real options analysis is a right and not an obligation. In the real option analysis it assumes that there is always uncertainty in every project and in this case the mining project, therefore it continues to tell us that the uncertainty wills, therefore, decrease as the time goes by (Viviers, 2011, pp. 75-98). Therefore in a given time in the mining company they should sit down evaluate the real options that they have the financial experts in the company and therefore e select the best course of action. In this example is that if the Net Present Value indicates as said earlier to have an average revenue of $ 25 million annually when the mining project is initiated in this year. The firm can only wait to start the project the next year if it the return rate does not itself decrease and therefore if the discount rate decreases then according to NPV it therefore not viable to take on the project (Schall, 2011, pp. 345). If the cash flows in the next year increase more and therefore making the profits to around $27 million in that annual year than the earnings of initiating in the next year are more than that in the for this year. Therefore, in this case, it shows that sometimes the NPV appraisal method can be inaccurate as compared to when you decide to put in place real options. NPV as an appraisal method is advantageous in that it shows a level of profitability and the fact that it discounts the future cash flows into the present value. The main disadvantage is that it decreases with the decrease in the discount rate and therefore it gives inaccurate results as compared to the real option appraisal method. REFERENCES Baurens, S., 2010, Valuation of metals and mining companies. Bennouna, K., Meredith, G.G and merchant, T., 2010. Improved capital budgeting decision making evidence from Canada. Management decision, 48 (2). Pp. 225- 247 Hausmann, R, Rodrik, D. And Sabel, C, (2013). Reconfiguring industrial policy. A framework with an application to South Africa. Jackson, J., 2010. Promoting energy efficiency investments with risk management decision tools. Energy policy, 38 (8) (2010 3865- 3873 Khamees, B. A., Al-foyuoumi, N. and Al- thuneibat, A.A., 2010, capital budgeting pracices in the Jordanian industrial corporations. 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