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Imagine that you are a senior manager of a company operating in Hong Kong in a highly innovative and competitive market with an annual turnover of US$500,000,000 and that you have a first draft of what can be a good business opportunity with an estimated investment (sunk) cost of US$50,000,000.
Your intuition is that it might be sensible to go ahead with the investment, but, given its size and the high risks involved in such a decision, the company should study very carefully the investment project. In order to do so you decided to organize a task force with the companyââ?¬â?¢s best economists, accountants and engineers.
You formally invited each member of the task force members for a first meeting, taking place next week, where you intend to discuss the specificities of the investment report, namely, the investment appraisal techniques and risk analysis to be used, the level of risk the company is able to take, as well as to give them your view about other issues related to the investment project which you consider important to be addressed in the investment report.
a) For the circumstances above, write what you believe could be a sensible memo to send to each member of the task force to invite them for the first meeting. In this memo you should briefly summarize the investment project, stressing its potential importance for the future of your organization and contextualizing the project in the companyââ?¬â?¢s current core business and expected industry developments.
b) Imagine that after 8 weeks of hard work, the task force gave you a 80 pages investment report where you can see that the project has a 5 years payback period and a positive US$15,000 NPV. After reading the investment report you feel, however, reluctant to invest. Describe possible reasons which could justify your reluctance to go ahead with the investment project, despite its positive NPV.
c) Discuss the potential weaknesses of the Internal Rate of Return (IRR), Net Present Value (NPV) and Payback Period (PP) techniques to assess investments for contexts with high market, technical and technological uncertainty, and the advantage of using the Real Options methodology in such cases. Your discussion regarding the advantage of the real options methodology must be supported by a brief introduction of the main aspects underlying the Real Option Theory and the use of relevant real options literature (3-6 relevant articles at least).
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Solution Summary
For the circumstances above, write what you believe could be a sensible memo to send to each member of the task force to invite them for the first meeting. In this memo you should briefly summarize the investment project, stressing its potential importance for the future of your organization and contextualizing the project in the companyââ?¬â?¢s current core business and expected industry developments.
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b) Imagine that after 8 weeks of hard work, the task force gave you a 80 pages investment report where you can see that the project has a 5 years payback period and a positive US$15,000 NPV. After reading the investment report you feel, however, reluctant to invest. Describe possible reasons which could justify your reluctance to go ahead with the investment project, despite its positive NPV.
There are numerous reasons for rejecting a project with positive NPV and fairly attractive payback period. One of the most important reasons is Return on Investment. The ROI generated by this project may be lower as compared to other initiatives or alternatives for the organization. In other words, the the opportunity to earn a better ROI on other projects may deter the firm to go ahead with this project, inspite of positive NPV and attractive payback period. The organization will reject this proposal because it will think that the alternative opportunity is much more attractive in terms of ROI over a longer term period. Organizations can thus reject projects with positive NPV because the internal rate of return or IRR and Return on investment may not be high enough or higher than the required return to undertake the project.
Another important reason for rejecting this proposal is lack of strategic allignent and fit of the project to the organization's strategy, philosophy, longer term vision and mission. Even though the project makes financial or economic sense and is financially attractive, the organizational management can reject it on the basis that is is strategically not a good fit for the organization's future growth and objectives and thus, it is better not to involve in such projects as there will be alternative projects or opportunities which will yield more strategic value to the organization in the longer run. If the project does not provide any strategic value, competitive edge or longer term strategic fit, it may not be attractive for the management to consider the project.
Often, projects with positive NPV and good payback are rejected because may find it too risky to go ahead with the project. Especially in dynamic and rapidly changing industries such as high technology industry or the mobile phone industry in our scenario, it may be too risky for the organization to undertake project of this size and scale. The market conditions which can become very volatile and uncertain prevents organizations to undertake risky projects in certain ...
Education
- BCom, SGTB Khalsa College, University of Delhi
- MBA, Rochester Institute of Technology
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