Page 215 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes

Notes A common error in choosing a discount rate for a project is to apply a WACC that
applies to the entire firm. Such an approach may not be appropriate where the risk of a
particular project differs markedly from that of the firm’s existing portfolio of assets.

In conjunction with NPV, there are several other measures used as (secondary) selection criteria

Example: Discounted Payback Period, IRR, Modified IRR, Equivalent Annuity, Capital
Efficiency and ROI.

Valuing Flexibility

In many cases, for example R&D projects, a project may open (or close) paths of action to the
company, but this reality will not typically be captured in a strict NPV approach. Management
will therefore sometimes employ tools which place an explicit value on these options. So,
whereas in a DCF valuation the most likely or average or scenario specific cash flows are
discounted, here the “flexible and staged nature” of the investment is modelled, and hence “all”
potential payoffs are considered. The difference between the two valuations is the “value of
flexibility” inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real Options Analysis
(ROA); they may often be used interchangeably:
1. DTA values flexibility by incorporating possible events or states and consequent
management decisions. In the decision tree, each management decision in response to an
“event” generates a “branch” or “path” which the company could follow; the probabilities
of each event are determined or specified by management. Once the tree is constructed:
(a) “all” possible events and their resultant paths are visible to management;
(b) given this “knowledge” of the events that could follow, management chooses the
actions corresponding to the highest value path probability weighted;
(c) then, assuming rational decision making, this path is taken as representative of
project value.

Example: A company would build a factory given that demand for its product exceeded
a certain level during the pilot-phase, and outsource production otherwise. In turn, given further
demand, it would similarly expand the factory, and maintain it otherwise.
2. ROA is usually used when the value of a project is contingent on the value of some other
asset or underlying variable. Here, using financial option theory as a framework, the
decision to be taken is identified as corresponding to either a call option or a put option –
valuation is then via the Binomial model or, less often for this purpose. The “true” value
of the project is then the NPV of the “most likely” scenario plus the option value.

Example: The viability of a mining project is contingent on the price of gold; if the price
is too low, management will abandon the mining rights, if sufficiently high, management will
develop the ore body.

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