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Essay: Tools for evaluating capital investments

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  • Published: 11 November 2015*
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Some traditional methods for evaluating capital investments are internal rate of return, net present value and cash payback. The internal rate of return method finds the interest yield of the potential investment by computing the rate that will discount the net annual cash flows to a net present value equal to zero. The company must consider that each new project must produce an internal rate of return higher than its cost of capital. Net present value is similar to internal rate of return as this method involves discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment (Weygandt, J. J., Kimmel, P.D., & Kieso, D. E., 2012). The cash payback method calculates the length of time it takes to recoup the costs of the original investment, as calculated from cash inflows.
A methodology to supplement the traditional methods could include; real options and Monte Carlo simulation. For example Johnson Controls plans to expand its automotive capabilities by developing a start/stop feature for all types of automobiles and is looking to invest in emerging markets they must: First decide if the automobile manufactures in those markets have designed vehicles that are capable of handling the complexity of a start/stop feature, Second factor in market conditions to determine how well automotive manufacturers are performing in current market conditions and lastly determining a method of measuring the benefits against the predetermined risks by choosing an analysis that will help management decide whether to invest in the project.
Real options are opportunities that are embedded in capital projects that enable managers to alter their cash flow and risk in a way that affects the project acceptability (NPV) (Zutter, C.J. & Gitman, L.J., 2009). The two key inputs into the real options valuation are the value of the underlying asset and the variance in that value. Examples of real options are abandonment the option to terminate a project to avoid or minimize losses and can increase NPV and lower risk, flexibility option allows companies to be flexible to changes in business conditions, growth the option to develop add-on projects and expand markets with little or no early commitment and timing the option to determine when certain actions pertaining to the project should be taken. The timing option allows the company to delay acceptance of a project, speed up or slow down implementation of a project and temporarily shut down a project due to market conditions and competition. Real options can use either the decision tree approach or simulations to assess the potential risks.
The Monte Carlo simulation is a tool that is very helpful when assessing different sources of uncertainty such as market demand, competitors’ pricing and production costs that gives a detailed analysis of associated risk.
As stated by Fiona Macmillan (2000):
Monte Carlo simulation is a method by which the risk and uncertainty encompassing the main projected variables in a decision problem are described using probability distributions. The output of a risk analysis is not a single value, but a probability distribution of all expected returns. The prospective investor is then provided with a complete risk-return profile of the project showing the possible outcomes that could result from the decision to stake money on this investment.
The risk analysis categorizes risks in low or high priority depending on how they will impact the project, giving decision makers a better understanding of the financial impact of the investment and therefore enabling them to make better capital investment decisions.
Assess the potential impact of inflation on planned capital investments in China and examine approaches for an accurate evaluation of the investments. Suggest how this knowledge may impact management’s decisions.
Inflation is the general increase in the price of goods and services over a period of time, which results in a decrease in the purchasing power of a currency. Inflation can affect exchange rates, prices and potential global capital investments. The real exchange rate refers to the purchasing power of the Yuan that increases in relation to American goods and the US dollar decreases in relations to Chinese goods when Chinese inflation is greater than in the US. Forecasting the performance of the Yuan by factoring in the long term expectations for conversion is important for any type of capital budgeting or long term investment opportunities in China. High inflation in China will result in revaluing the Yuan by causing the Chinese to alter their exchange rate policy and appreciate the Yuan. Foreign direct investment (FDI) is a business entity in one country, making an investment in an entity located in another country. Inflation can affect the inward foreign direct investment, meaning the inflows of investments in China. Due to the huge impact of inflation raw materials are at a higher cost along with an increase in labor wage which leads to an increase in production costs. This will lead to the Chinese and other companies looking to invest have to sell their products at a higher cost to consumers around the world. Both China and the investing company would see a decrease in demand for those products which make investing in China a risky business venture.
M. Kannadahasan noted that inflation influences two aspects; the cash flow and discount rate and that the cash flow and discount rate should be matched, which means nominal discount rate with nominal cash flow or real discount rate with real cash flow in order to reach accurate results (Ead, N., 2012). In respect to the discount rate, inflation can be adjusted in the premiums and the rate of inflation should also be reflected in the cash flows. To find the risk adjusted discount rate (RADR), compute the market interest rate and that will give you the net present value. Many companies determine the risk adjusted discount rate by adjusting their existing required return. To analyze inflation using cash flows Johnson Controls must estimate the amounts of the cash flows based on today’s prices which is called the estimated cash flow. Escalation rates can be used to estimate future expenditures and are like inflation rates, which can differ between the elements of the cash flow. When prices escalate the cash flow components are obtained in actual dollars and to obtain the real dollars cash flow the company would deflate the amount in each period using the general inflation rate. When factoring in inflation the company must compute the actual dollar cash flow with the market Minimum Acceptable Rate of Return (MARR) to find the Net Present Worth (NPW) to decide whether it is an acceptable investment. The presence of inflation can be a deterring factor for investors, especially due to unpredictable price levels and low real returns. If Johnson Controls project management team properly factor in the risk of inflation as outlined above when looking to invest in China they can make the necessary adjustments needed to get a good rate of return for their investment.
Contrast the modifications you would make in evaluating the projects to increase internal capacity in North America to evaluating expansion projects in global market and how this information will impact the decisions made related to expansion.
Johnson Controls automotive and building divisions currently have projects in North America and other countries across the globe. Automotive industry production in China rose by 9 percent annually, nearly doubling the rate it grew in North America. The company however has seen in its auto battery segment more than three fourths of its sales generated from North America. Many North American auto component suppliers are in an intense cost competition with manufacturers from low-cost countries offering many components at lower costs. Suppliers may have to address the issue by passing on the cost to consumers (higher sticker prices) or avoid it all together with changes to regulatory standards. In their building segment the company is looking to expand in the energy services field in the mid and complex markets. The company feels the service and retrofit markets in North America are larger than they are elsewhere, and continue to grow as businesses decide to improve their existing buildings verses engaging in new construction. The company looks to expand in emerging markets such as China, India and Russia, where they can take advantage of their rapid economic growth rate and higher expected returns. The company should continue to look to invest in mature or developed markets such as North America due to its advanced innovative capabilities, large market capitalization and high levels of liquidity.
According to Arthur Pinkasovitch (2014):
North American market returns arguably follow a pattern of normal distribution. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be valued using the same type of mean-variance analysis.
Many emerging markets carry higher investment risks such as inflationary pressures, rising interest rates, economic uncertainty, political and currency risks (foreign exchange exposure). Long term economic uncertainty in some of the areas in which Johnson Controls operates such as South America, Asia, Middle East, Central Europe and other emerging countries could result in the disruption of markets and negatively affect cash flows from our operations to cover our capital needs and debt service (United States Securities and Exchange Commission, 2011). Johnson Controls management team must take all of these factors into consideration when deciding to increase internal capacity in North America or to expand globally. Its automotive division is currently doing well in China, however if they look to acquire low cost suppliers in North America they can increase profitability without expanding globally.
Examine the benefits of using a sensitivity analysis in evaluating the projects for Johnson Controls and how this approach can provide a competitive advantage for the company.
A sensitivity analysis is a way to predict the outcome of a decision by using a number of outcome estimates to get a sense of the variability among potential returns (Weygandt, J. J., Kimmel, P.D., & Kieso, D. E., 2012). Johnson Controls operates across three business segments Automotive Experience, Building Efficiency and Power Solutions in which they are looking to invest in projects globally within those divisions. Sensitivity analysis will better prepare Johnson Controls project managers in case the projects do not make the expected returns so they can further analyze the projects before making an investment. The viability of investment projects is based on Discount Rate, Internal Rate of Return (IRR) and Net Present Value (NPV) which is the most widely used measures of a projects worth.
When computing measures of project worth as stated by Harold Marshall (1999), for example:
Sensitivity analysis shows just how sensitive the economic payoff is too uncertain values of a critical input, such as the discount rate or project maintenance costs expected to be incurred over the projects study period. Sensitivity analysis reveals how profitable or unprofitable the project might be if input values to the analysis turn out to be different from what it is assumed in a single answer approach to measuring project worth.
The most common sensitivity approaches is to estimate the NPV’s associated with pessimistic (worst), most likely (expected) and optimistic (best) estimates of cash inflow. The range is determined by subtracting the pessimistic outcome NPV from the optimistic outcome NPV.
The benefits of using a sensitivity analysis is first, it helps identify the key variables which influence the project cash flow forecasts and benefit stream (helps to decide where to spend extra resources in data collection and improving data estimates). Second, it is a technique to help in anticipating and preparing for the ‘what if’ questions based on different scenarios and their potential outcomes resulting from changing conditions that are asked in preparing and defending a project. Third sensitivity analysis does not require the use of probabilities and can be used on any measure of project worth. Lastly the analysis can be used when there is little information, time and resources. When managers appraise projects before committing resources it gives them a clearer understanding of what value the project will have on the overall success of the company. When Johnson Controls managers can identify, analyze and mitigate unfavorable outcomes it can provide tranquility to the company and a strong competitive advantage.

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