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Project code name Vandone

a)

Dear Colleagues,

As the 2nd biggest game console producer in the industry we are expecting another

challenging year ahead. After launching our latest game console years ago, a new exciting

opportunity is presenting right before us today. A small company !orge" #nc. located in $an

%ose area initially dedicated to producing D animation and simulation e&uipments for the

mo'ie industry has come up with some ground brea(ing technologies. #n their latest project

code named Vandone, different engines are in the final stage of de'elopment, one for

natural D display, one for D simulation and processing and the last one, an ultra fast special

purposed central processor to coordinate between first 2 engines and other peripherals. )he

result will be ama*ing 'irtual reality experience at a le'el perhaps only a'ailable to military

use before but now achie'able at possibly ++-,--- of the costs. #f the technology can be

applied to our latest line of action games, it is going to be a (iller app and enabling us to

e'entually ta(e o'er $ony to become number one player in the world and distant oursel'es

from the rest for a good while, so consider this could be the most critical project for years to

come.

)hough !orge" is the technology leader in the field, it has not yet recorded a profit through

its years of operations. #ts si*e is really limiting its sales and mar(eting functions. And due

to the recent mar(et uncertainty, in'estors are reluctant to pour in the amount re&uired to (eep

+


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the new project going. !orge" is now in a position for ac&uisition.

)he cost for ac&uiring this new technology and implementation will be around /$01-mil.

)his technology is expected to be obsolete in years.

)herefore #3m calling a team of elite members each accountable for finance 4 accounting,

technology 4 engineering, sales 4 mar(eting and human resources wor(ing together to

conduct a thorough e'aluation of this golden opportunity. # cannot stress enough the

importance of this project and # am assuming all of you will be attending the first meeting

next !riday to discuss the specifications of the in'estment report. 5e will ha'e to consider a

number of sensible in'estment appraisal approaches e.g. PP, 6PV 4 #77, and wor( out the

weighting of the results by the rele'ancy to our business. 8igh le'el plans for wor(ing out the

financial and mar(eting data necessary for the analysis and produce the full in'estment report

in months time will also be drafted as the result of the meeting. )hough detailed data may

not be a'ailable at this stage, it should not pre'ent us from start thin(ing about how this

project could cope with the organi*ation3s o'erall strategic, what sorts and le'el of resources

will possibly re&uired to enhance the chance of success and what potential impacts it might

ha'e on our current business especially in terms of resources and cash flow and what happen

if the new technology does not turn out as expected. $ome preliminary ris( assessment using

both &ualitati'e and &uantitati'e analysis techni&ues will also be expected. )he company is

counting on you for pro'iding &uality information and professional opinions and you are

trusted to (eep the information within this team for the time being. Please feel free to pro'ide

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any additional information that you thin( is rele'ant.

b)

After months hard wor(, all members of the tas( force ma(e excellent contributions to

complete this comprehensi'e in'estment report. !inancial and accounting department wor(ed

out the best possible arrangement of the ac&uisition and estimated the initial in'estment costs.

)he optimal cost'olumeselling price were put together by the collaborati'e effort across all

departments with most sophisticated analysis, precision modeling and e'aluation, and based

on which, the annual income forecasts for the project were deri'ed.

)he pros and cons below are extracted from the conclusion of the report 9also refer to )able +

in the Appendix for detailed figures:

Pros

; positi'e 6PV

; higher than hurdle rate #77

; P# higher than brea(e'en point i.e.


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; short project life time

; considerable potential impact on the current ratio for the first few years when the project

starts without proper financing

7esults in table + are all calculated from the discounted 'alues since the cost of capital is

such a critical component in the high ris( in'estment analysis. )ime factor is simply too

important to be ignored.

!rom the figures in table +, it seems li(e a good in'estment. Positi'e 'alue of 6PV indicates

the project is profitable, 6PV of /$0+1,--- is actually &uite comparable to the past projects

of similar si*es, though far from the highest, it is still currently the most promising project on

hand. #77 and P# 'alues basically are in line with what the 6PV implies. =ut 6PV is

considered as the most reliable mean of measurement and hence in our analysis it is 'alued

most.

Paybac( time of 1 years is only reasonable with an in'estment of this magnitude but not

considered 'ery fa'orable, howe'er ine'itable in many cases. >specially when competitors

are expected to catch up in around ? to 1 years, and e'entually this technology is expected to

become obsolete in the th year. Also by year , the income is merely co'ering all the

'ariable costs and fixed costs, it is only sensible to put an end to the project there in time to

a'oid negati'e net cash flow. Considering the project life will end shortly, only + year after

the brea(e'en point, it means a rather limited period of the project3s real contribution to the

increase in the wealth of the business. )his new technology alone cannot guarantee us to be

on top in the future, it does not pro'ide us the ad'antage sustainable long enough, there is

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expiration for e'ery new technology.

=ase on the outcome of the report # am still not con'inced that we should go ahead with the

project, or perhaps not now, or maybe there are other options we should consider. Although

the company possesses the best tool in trade for mar(et research and forecasting, any forecast

in the technology field beyond years is a big stretch. Any wea( lin( in the execution or any

unexpected in the mar(et may end up with a total loss of /$01-mil minimum. )he ris(

outweighs the potential profit in this case. )he report did not gi'e the full picture of the

underlying ris(s, though there is a ris( premium included in the calculation of cost of capital,

it failed to &uantify the uncertainty and its impacts. #t failed to pro'ide the price of options to

bail out for example. @aybe that is just one of the shortcomings of the con'entional

in'estment appraisal techni&ues.

c)

@acaney > and Atrill P 92--: mentioned the 6et Present Value 96PV: and #nternal 7ate of

7eturn 9#77: are the 2 most often used techni&ues for both /B and /$ businesses as some

recent sur'eys had indicated, both techni&ues each accounts for about - of the adoption

rate, while the paybac( period method 9PP: comes in the rd place at about -. 8owe'er

through the abo'e in'estment appraisal analysis we learnt that each of the classical

in'estment appraisal techni&ues has its own wea(nesses.

7ee'e %@ and 5arren C$ 92--: described the major disad'antage of the 6PV method as

Ethe net present 'alue method assumes that the cash recei'ed from the proposal during its

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useful life can be rein'ested at the rate of return used in computing the present 'alue of the

proposal. =ecause of changing economic conditions, this assumption may not always be

reasonableF. )hat means the 6PV method is accurate only when the future discount rate turns

out to be as expected and remains unchanged throughout the project life time.

E)he main disad'antage of #77 is the fact that it does not correctly address the &uestion of

wealth generation. #t could therefore lead to the wrong decision being made. )his is because

#77 would, for example, always see an #77 of 21 per cent being preferable to a 2- per cent

#77, assuming an opportunity cost of finance of, say, +1 per cent. Although accepting the

project with the higher percentage return will often generate more wealth, this may not

always be the case. )his is because #77 completely ignores the scale of in'estment.F

9@acaney > and Atrill P, 2--:.

@acaney > and Atrill P 92--: critici*ed the PP method as not being concerned with the

profitability of projectsG it is concerned simply with their paybac( period. )herefore the cash

flows generated beyond the paybac( period will be ignored.

All three of these classical techni&ues howe'er ha'e a common limitation. EAll capital

in'estment analysis rely on factors that are uncertain. !or example, the estimates related to

re'enues, expenses, and cash flows are uncertain. )he long;term nature of capital in'estments

suggests that some estimates are li(ely to in'ol'e uncertainty. >rrors in one or more of the

estimates could lead to incorrect decisionsF 97ee'e %@ and 5arren C$ 2--:.

A common wea(ness of all these classical techni&ues is that as they only deal with the

expected cash flows, ignoring the flexibilities, and they are incapable to respond to


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uncertainties, which are critical for assessing in'estments with high ris( elements in'ol'ed.

#n reality, in'estors should ha'e flexibilities when ma(ing the in'estment decisions, for

example, the option to defer, expand or abandon a project. Paddoc( %, $iegel D7 and $mith

% 92--+: also critici*ed the discounted cash flow approaches for their fi'e major

wea(nesses.

+. )he timing of the de'elopment may ma(e differences in the 'aluation, and the choice of

timing for the DC! calculations is therefore arbitrary and subject to error.

2. Different parties may ha'e different assessments of future statistical distributions and this

may lead to di'ergent 'aluations.

. )he choice of ris(;adjusted discount rates is subject to a great deal of subjecti'ity and

error.

?. )he DC! calculations, particularly @onte Carlo applications, are 'ery complex and costly.

1. =ecause data is often relati'ely sparse at the bidding stage, the assessment of 'arious cost

and 'alue can widely 'ary by different parties.

7eal Hptions Analysis pioneered by =rennan and $chwart* 9+I1:, and @cDonald and $iegel

9+I:, and summari*ed by Dixit and Pindyc( 9+II?:, and )rigeorgis 9+II: is the solution to

the abo'e problems by 'aluing the choices. EA real option is the right, but not the obligation,

to ma(e an action 9e.g., deferring, expanding, contracting, or abandoning: at a predetermined

cost called the exercise price, for a predetermined period of time J the life of the optionF

9Copeland ) and Anti(aro' V, 2--:, E7eal Hptions Analysis 'alues the flexibility to respond

to uncertain e'ents J net present 'alue techni&ues do not and conse&uently under'alue


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e'erythingF.

)here are 2 major ad'antages of 7HA o'er the classical techni&ues. !irst, 7HA ta(es into

account the 'olatility of the underlying asset. 7eal Hption can be modeled using =lac( and

$choles3 9+I: partial differential e&uation, =rennan and $chwart*3s 9+II: finite difference

methods, the binomial option 'aluation method by Cox, 7oss, 4 7ubinstein 9+II: , @onte;

Carlo based methods by =oyle 9+I: or a no'el approach, !u**y Pay;Hff @ethod by

@athews 4 Datar 92--:, @athews 4 $almon 92--:, and Datar 4 @athews 92--?: for the

'aluation of the option pricing, and in most cases the underlying is assumed to follow a

geometric =rownian motion which is a function of 'olatility. $econd, 7HA Eenable

companies or managers to 'alue projects more accurately by incorporating managerial

flexibilities into the 'aluation modelF 96ewton DP, Paxson DA and 5iddic(s @, 2--?:. #t

e'aluates the in'estment options such as deferral, expansion, contraction, switching, or

abandonment. !or example, when considering the defer option, Eit is optimal to defer

in'esting until the present 'alue of the benefits from a project is double the in'estment costF

9@cDonald 7 and $iegel D, +I:. )hey also suggested that adopting a project at suboptimal

timing can easily end up with a lost range from +- to 2- percent or more of a project3s 'alue.

@any more sophisticated models ha'e been deri'ed based on the principle of 7HA to

e'aluate the flexibilities of the real mar(et situation. A*e'edo A! and Paxson DA 92--:

deri'ed a real options model in a game theoretic context where the optimal time to adopt a

new technology is affected by three types of uncertaintiesK mar(et, technical and


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technological uncertainty. )hey concluded that Ethe higher the probability of a second

technology arri'es in the mar(et the later the leader adopts the incumbent technology and the

lower the 'alue of being the leader with the incumbent technologyF. Loto @ and )a(ashima

7 92--I: formulated firm3s capacity planning and ma(e or buy decision also based on the real

options model.

7eal options analysis is a great tool for in'estment decision ma(ing, the applications of this

approach and situations that are applicable seem unlimited. Hnly the limitation of the lac( of

a'ailable data may sometimes restrict its practical use.

word countK 2,2--

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Appendix

Project

Vandone

cost of capital rate 8%

Year 0 1 2 3 4 5 6

acquiring the core technology -

35,000,000

infrastructure setup -

15,000,000

salary -

3,000,000

- 2,500,000 -

1,500,000

-

1,500,000

- 500,000 -

396,000

marketing expense -

2,500,000

- 4,000,000 -

2,000,000

-

900,000

- 500,000 -

500,000

fixed operation overhead -

600,000

-

600,000

-

600,000

-

600,000

- 600,000 -

600,000

income

20,000,000

35,000,000

11,000,000 9,000,000

6,500,000

1,500,000

Net Cashflows -

50,000,000 13,900,000

27,900,000

6,900,000 6,000,000

4,900,000

4,000

Present Values, at 8% -50,000,000 12,870,370 23,919,753 5,477,442 4,410,179 3,334,858 2,521

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Cumulative iscounted

Cashflows

-50,000,000 -37,129,630 -13,209,877 -7,732,434 -3,322,255 12,603 15,123

Discounted Payback 5

NPV 15,123

IRR !015"

Pro#itabi$ity Inde% &"' 100!03"

Table

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References

A*e'edo A! and Paxson DA 92--: )he Combined >ffect of @ar(et, )echnical and

)echnological /ncertainties on 6ew )echnology Adoptions

=rennan @%, $chwart* >$ 9+I1: >'aluating 6atural 7esource #n'estments. Journal of

Business

Copeland ) and Anti(aro' V 92--: 7eal Hptions A Practitioner3s Luide

Dixit AB and Pindyc( 7$ 9+II?: #n'estment /nder /ncertainty

Loto @ and )a(ashima 7 92--I: #n'estment, Capacity Choice and Hutsourcing under

/ncertainty

@acaney > and Atrill P 92--: Accounting an #ntroduction

@cDonald 7 and $iegel D 9+I: )he Value of 5aiting to #n'est. Quarterly Journal of

Economics Vol. 101

6ewton DP, Paxson DA and 5iddic(s @ 92--?: 7eal 74D Hptions. International Journal of Management Reviews volume 5/

Paddoc( %, $iegel D7 and $mith % 92--+: Hption Valuation of Claims on 7eal AssetsK )he

Case of Hffshore Petroleum eases !"e Quarterly Journal of Economics# $ugust 1%&&

7ee'e %@ and 5arren C$ 92--: Principles of !inancial and @anagerial Accounting

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