Investment Appraisal Under Uncertainty
Investment Appraisal under Uncertainty Question a Internal Memo Date: November 15, 2012 Subject: Investment report To: Mr - Investment Appraisal Under Uncertainty introduction. Michael the Chief Engineer Mr. Richard the accountant Mrs. Rachel the economist From: Alex the Managing Director Hello, everyone, I would like to present an introduction and brief description of the investment project to you, and wish to make sense as much as possible.
To begin with, this project is about creating an online-based business that specializes on consumer goods such as fashion garments, imported electronic products and food, nutrient products and many others like that. Generally speaking, all kinds of products have to be easily stored, delivered and legally accepted by both Hong Kong and China mainland government. Probably, some of you may wonder why we need to enter an online market for consumers, since there are too many players already and the profitability rate might be squeezed out by those first movers.
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Apart from, you may think that we have US$ 5,000,000,which could either create a unique business or enable to enter some business areas with large amount of initial capital requirement but higher profitability guarantee. In response, I would like to explain the reasons why this investment project could be a good business opportunity for us, and the predicted net cash flows would be substantially and sustainability. In the first place, it is necessary to emphasize that we aim to construct a solid electronic business platform that base in Hong Kong but primarily focuses on China mainland market.
More importantly, we might need to invest a substantial number of money on supply chain management, marketing, channel constructions and our own logistic networks. There are so many reasons to support why we have to focus on China mainland consumer goods market, not only the second largest economy in the world or the two digits or highly one digit rate of economic growth rate for past and following decades, but the really strong demands from 1.
3 billion people for nearly all kinds of durable products with good quality from all over the world. Besides, Hong Kong has a unique advantage in transferring products from rest of the world to mainland due to a set of political, economic and cultural considerations, in other words, the choice of headquarter in Hong Kong could bring a set of benefits in terms of favored duty policies, transportation advantages and receiving latest market information or chasing new business opportunities.
More specifically, our targeting customers are those young people and couples with good education background (generally bachelor degree or above), reasonably good household income (Approximately 10,000 RMB in terms of 1,000 pounds), and they are engaged on chasing high living standards. The reasons are simply summarized that they have a relatively strong purchasing power with open-minded characteristics.
Correspondingly, the categories of products in our online stores needed to be more specified as the range of medium between top grades of products in order to satisfy the preferences of that group of customers, and we also need to import a large volume of stocks. Meanwhile, it is necessary to construct a very stable and efficiently online platforms, in other words, a friendly and popularity website is essential to the success of our business, which means a large amount of money needed to be invested for technical preparations and operations.
In terms of the vision of business strategy in our company, it might be summarize as the Hong Kong based investment company that focuses on chasing the business opportunities from key emerging markets, especially in the Asian-Pacific region. It is because that Hong Kong is famous for international free port, one of the most important financial centers in the world and also has many particular links with mainland China or other countries in this region. The investment project is very fit for the strategic version of our company, since it would make use of unique advantages that only in Hong Kong has.
More importantly, it is predicted that the launch of new investment project would have particular contributions to the company’s overall performance through chasing key opportunities and reaping generous profits from China mainland. Now I want to explain why I invite you guys into this task force. Rachel: I know you are very good at forecasting business perspectives with your sophisticated mathematical models and abundant economic knowledge. Therefore, I think you might be very fit for the role of consultant in this investment project.
It is because that we have to construct our own marketing and logistic networks, and we also need to choose the key submarkets in China mainland to initially launch our business. As we know, these kinds of business activities are all needed to implement professional instruments for marketing analysis, such as data collections or data mining. Consequently, I think you are the best candidate fit for this task, and the success of investment would not only bring generous monetary benefits to our company and yourself, but also improve your reputations and spur your self-esteem.
Richard: I know you are very familiar with corporate accounting and comprehensive skills for financial management. It is particularly important to invite you join our group and provide experts suggestions for financial decision makings, addressing the daily transactions issues, dealing with the considerations of taxes and utilizing the use of financial resources for this investment project and maximizing our profits. I believe you can do perfectly well and make all of us better of.
Michael: I do not want to say anymore to you but want to ask Mr. genius for help in terms of our IT issues. You know, the constructions and operations of online platform are extremely important to our whole business. We aim to initially launch a powerful and friendly used website in order to obtain strong competitiveness over other players. In other words, we must have the most excellent technical team and enable to guarantee the completion of huge volume of online transactions properly.
I know you are the only best candidate for this job, please do not refuse me. Signed Oscar The Managing Director Question b After serious reflection and evaluation of your investment report, I’m afraid to say now I’m reluctant to invest. There are two reasons in my consideration. First, frankly speaking, there are many potential risks of this investment project. To sum up, there are two main types of risks that associate with this project, the business/market risk, and the risk that arising from economy situations.
The first one is easy to understand that there are many players in retailing business or online business in China, and the competitions are fierce, consequently, it is not very clear that whether the launch of our business could achieve the predicted outcomes. In addition, the particular business and regulation environment in mainland China might create substantial barriers for new entrants like us, especially we are based in Hong Kong and might not be very familiar with local conditions.
In other words, it cannot be fully ruled out that local government, competitors or any other market players could make extremely difficult operating conditions for us. The second risk is about the Chinese overall economy situations. Many people know that China has become the second largest economy in the world recently, and the Chinese economic growth might support at least half of the global economic growth rate (The Economists, 2012). However, there are few external observers recognize that the risks of economic growth slow down significantly and suddenly. [pic] (National Bureau of Statistics, China Statistical Yearbook, 2011)
From the graph, it might be relatively easy to identify the potential downward trend for economic growth. In reality, the very recently BBC reported that the third quarter of GDP growth rate in 2012 was 7. 4%, which seems to be slower than all previous figures in this graph, but the report claimed that China was trying to stabilize and rebound the economy (BBC News, 2012). To sum up, there are some uncertainties that centered around the prospects of Chinese economy, and the worst scenarios might bring significantly damages to any business that primarily activities are in China.
The second reason for me to reluctant is the payback period for this investment project might be relatively longer than originally expectations. It is necessary to recognize that with a five years payback period, there might be many uncertainties or risks that associated with the investment project. Particularly, the business we are going to do is an online-based consumer products provider, which is in a highly competitive market with a rapidly change of customer behaviors and dynamic change of consumer preferences.
In other words, it might not be reasonable believe that our new online business could generate enough cash flows either during the payback period or in five years. As Narayanan (1985) argues that managers prefer quick returns of their investment when implementing payback method, which means the payback period should be reasonably lower than many other types of investment projects. The NPV of this investment is $50,000, which means the rate of return for this investment is only 10%. Hsieh et al.
(2006) summarize that the aggregate rate of return to investment is about 20 percent in China since 1998, which is twice of the rate for this project, in other words, the choice of this investment project means the inefficient allocations of financial resources, and bear a significantly loss of opportunity cost. Question c According to the definition offered by INVESTOPEDIA, the Internal Rate of Return is a discount rate that ‘makes the net present value of all cash flows from a particular project equal to zero’ ( INVESTOPERIA, 2012, retrieved from http://www.
investopedia. com/terms/i/irr. asp#axzz2E0hpZmDx). In simple words, the higher IRR means the better investment project. However, ‘the IRR calculation itself assumes interim investment values that are mechanically generated by the IRR equation itself and will almost surely differ from the true interim values of the project under consideration’, and the IRR result might not be the same as the real rate of return (Altshuler & Magni , 2012, p. 219 ). In fact, the conclusion might be particular important to the company that operating in high competition and uncertainty market.
In terms of Net Present Value method, Berkovitch & Israel (2004) argue that the NPV method might lead to inefficient capital allocations, instead, they promote other methods as better criteria to make investment decisions such as the IRR (internal rate of return) and the profitability index. Besides, Thomas (1995) points out that the discounted present value methods cannot address the problems of the future contingent events. As a result, when the company is in a highly competitive market, it is necessary to recognize many unanticipated or contingent events would happen, and the accuracy of NPV method would be questioned.
In terms of Payback Period method, there are two main drawbacks, (i) ‘it does not take any regard of returns after the payback period and’, (ii) ‘it ignores the timing of the returns’ (Lefley, 1996, p. 209). In this case, the investment project is not a short term, but at least in a medium to long term business, the returns after payback period is extremely important, and the timing would be a significant issue as well. After analyzing the three traditional methods of investment, it is necessary to introduce a new methodology, which is the Real Option Theory.
Still based on the definition of INVESTOPEDIA, the real options means that ‘the opportunities to expand and cease projects if certain conditions arise’ (INVESTOPEDIA, 2012, retrieved from http://www. investopedia. com/terms/r/realoption. asp#axzz2E0hpZmDx). Moreover, the real options approach might play the particular impacts on supporting the investment decision-making and capital budgeting, it is because that the ability to take the future flexibility in into the value considerations (Trigeorgis, 1996, Amram & Kulatilaka, 1999 cited by Bowman & Moskowitz, 2001).
In reality, there are many uncertainties or risks concerns in the discussions of this investment project, however, Amram & Kulatilaka (1999) argue that the ‘uncertainty creates opportunity’, and it is possible to reap generous business opportunities by making use of the option- pricing framework. Considering the potential business of our company will be doing, it might be particular important to implement this financial instrument, decrease the potential risks and increase expected payoffs.
Technically speaking, Tong & Li (2011) find that the highly competitive market with huge amount of uncertainties would force investment project maintain flexibility, and ‘firms attach greater value to the real options embedded in initial CVC investment via-a-vis acquisitions’ (Tong & Li, 2011, p. 670). The CVC is a special term in their paper, which called corporate venture capital. In fact, the term might be very fit for implementing in our investment, since the idea of creating a new online business share many common considerations with the venture capital.
References Amram, Martha, Nalin Kulatilaka. 1999. Real Options: Managing Strategic Investment in an Uncertain World. Harvard Business School Press, Boston, MA. Altshuler, D. & Magni, C. A. , 2012. Why IRR is Not the Rate of Return for Your Investment: Introducing AIRR to the Real Estate Community. Journal of Real Estate Portfolio Management. 18(2). BBC News, 2012, retrieved from http://www. bbc. co. uk/news/business-19975112. Bowman, E. H. & Moskowitz, G. T. , 2011. Real Options Analysis and Strategic Decesion Making. Organization Science. 12(6). Berkovitch, E.
& Israel, R. , 2004. Why the NPV Criterion Does Not Maximize NPV. The Review of Financial Studies, 17(1). INVESTOPEDIA, 2012, retrieved from http://www. investopedia. com/terms/i/irr. asp#axzz2E0hpZmDx INVESTOPEDIA, 2012, retrieved from http://www. investopedia. com/terms/r/realoption. asp#axzz2E0hpZmDx Lefley, F. , 1996. The Payback Method of Investment Appraisal: A Review and Synthesis. International Journal of Production Economics. No. 44. Li, Y. & Tong, T. W. , 2011. Real Options and Investment Mode : Evidence from Corporate Venture Capital and Acquisition.
Organization Science. 22(3). The Economists, 2012, retrieved from http://www. economist. com/blogs/freeexchange/2012/01/world-economy. Thomas, O. 1995. Expected Internal Rate of Return. Actuarial Research Clearing House, No. 2. Hsieh, Chang-Tai. , Bai, Chong-En. & Qian, Yingyi. , 2006. The Return to Capital In China. National Bureau of Economic Research. National Bureau of Statistics, China Statistical Yearbook, 2011 Narayana, M. P. , 1985. Observability and the Payback Criterion. The Journal of Business. 58(3).