# Term Financial Management Work 4

Long-Term Financial Management Work 4

This task is about analyzing a real option. You will prepare a report for the CFO and management by answering the questions in this task. The firm has to decide whether to invest \$30 Million in a new enterprise system to help manage resources and meet customer demand in the face of considerable technological and market uncertainty. There can be a good or a bad result for this investment. Good Result: A good result has a probability of .5 of occurring. Here the planned cost reductions have been realized and better integration of the supply chain is possible. Annual benefits under this scenario equal \$10 million in after-tax cash flow per year over the life of the system which has been estimated as 8 years. Bad Result: The system proves difficult and the growth in market demand for the product is lower. Annual benefits under this scenario are \$2 million in after-tax cash flow per year for the 10 years. Real Options: For these capital investments you must analyze the nature of risk in this capital investment and decide on how to adjust for that risk. You have decided to utilize an NPV analysis of the project. Now you must define project risks and utilize the concepts in real options to adjust or plan for that risk. It will be best for you to provide an option tree graphic to show the options and then provide a table with the computations showing how you would compute the value of this project.

## Term Financial Management Work 4

Scenario #1: Use 8% cost of capital in computations and compute the good result and poor result NPVs. Calculate the real option NPV using the results computed.

Scenario #2: Use a risk-adjusted cost of capital against the good scenario above which can adjust for risk variables such as experience with the focus of the project, chance of change to estimated variables (revenue, costs, timing, etc.), and/or the potential change in the cost of capital in the future. Compute the new NPV using a variety of risk-adjusted discount rates. Justify your computations in determining how you have adjusted discount rates for risk. Discuss the outcomes from your adjustments and how you would apply them in capital expenditure justification.

Concept Check: Risk in finance is a deviation from expectation. We use this concept in computing beta by mathematically computing the Security Market Line (SML) for assets and then computing the deviation of the individual assets against the market. The utilization of real options analysis in project evaluation is similar to these concepts and the concept of weighted average cost of capital.

Helpful Hint: Risk adjustment in project management can be achieved in several manners. In the case of real options, we first need to identify the different paths our investments can take and then the probability that each event may occur.

Work 5

This task has the CFO asking your team to look at how the market value of XYZ is compared to

the industry. You need to come up with a justification for the capital investments being made.

Your team discusses this and has determined EVA (Economic Value Added), as well as MVA

(Market Value Added) concepts, need to be established for the corporation.

Use the following table as a guide:

*12% here is a plug number. This will be different from the number you calculated in Task 3.

Compute the P/E ratio and market capitalization for the Industry Average, Competitor 1, and

BEB.

Compute the MVA and EVA for all 3.

Compare and contrast the ratios; what do the ratios convey to the investing public? How would

you present these internally and externally? Make recommendations to management from

Concept Check: Market value added focuses on the market price and relation to invested

capital while economic value is based on operational profitability compared to invested capital.

These measures help us evaluate our organization internally and externally to help identify gaps

and opportunities.

Helpful Hint: Ratios, by themselves, tell us very little; it is only when they are placed in the

context of the market, industry, or competition that they truly can be powerful.

Work 6

Leasing: You are to use your critical thinking skills, collaboration techniques, creative problemsolving tools, and communication skills in the following scenario: Your company (XYZ) is considering leasing solid oxide fuel cells that produce electricity on-site. You and your team need to perform analysis to support the decision-making process. The lease lasts for 12 years. The lease calls for 13 payments of \$15,000 per year with the first payment occurring immediately. The fuel cells would cost \$90,350 to buy and would be straight-line depreciated to zero salvage over 12 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 7.5%. The corporate tax rate is 36%.

1. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in years 1-12?

2. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 0?

3. What is the NPV of the lease relative to the purchase?

4. What would the after-tax cash flow in year 12 be if the asset had a residual value of \$5,000 (ignoring any possible risk differences)?

Concept Check: Understanding which cash flows are relevant is key to determining the best financing methods or project acceptance. It helps to detail all your assumptions within the model since questions may arise years after the initial construction of the model.

Helpful Hint: Creating a timeline with corresponding cash flows is usually helpful. You should also do the NPV calculations showing your formula so if anyone wishes to change the variables they will know how to proceed