Posted: February 18th, 2015

Richie Plc: Capital Rationing and Real Option Analysis

Richie Plc: Capital Rationing and Real Option Analysis

Task
It has been four months since you took a position as an assistant financial analyst at Richie’s Plc. During that time, you have been promoted and you are now working in a Project Management team as a Financial Analyst, reporting directly to the CEO.

Within this role your first assignment is to evaluate the potential value added to Richie’s Plc. from the proposed Capital Investment Projects.
Project A    Project B    Project C    Project D
Initial Investment    (500,000)    (400,000)    (120,000)    (1000,000)

Detailed information is provided in attached Appendix.
Task 1. Utilising academic underpinning, explain the concepts of Capital Rationing and Real Options.
Task 2. Examine the extent of adoption of these tools and discuss their impact on the decision making process in an organisation. You must verify the relative validity of NPV and Real Options whilst appraising risks and uncertainty.

Task 3.  Using the information in the Appendices, assess the potential value added to Richie’s Plc. from the proposed Capital Investment Project using the following finance modelling techniques:

Using information provided in Appendix 1 complete i, ii and iii
i.    Calculate Net Present Value on the portfolio when:
a.    The projects were independent and indivisible, and the company had £1.2 million to invest.
b.    The projects were independent and divisible, and the company has up to £1.5 million to invest.

ii.    Draw Decision Tree and calculate the Net present value:
Project manager is happy to go ahead with the project chosen using independent and indivisible criteria but is uncertain whether to start the project now or to wait for two or three years. Draw a decision tree and evaluate the option.
iii. Run Monte Carlo Simulation:
You have been further asked to run Monte Carlo simulation for 1000 samples for the chosen project, to assess the NPV at random variables. You results must highlight the following data and comment on these

PV Mean
NPV Standard deviation
Maximum value
Minimum value

Using information provided in Appendix 2 complete iv and v
iv. Perform sensitivity analysis
Calculate the cash flows for the investment under the base-case scenario and estimate the impact of the selling price and the unit cost on the profit after five years (Table 1). You must use your own five different reasonable figures for selling price and unit cost.
v. Perform Scenario Analysis
Estimate the NPVs for the base-case, worst-case and the best-case scenarios (Table 2) considering no changes are estimated and NPVs remain constant every year.
Task 4. Conclude your report and provide recommendations as identified using the various financial modelling techniques which will help the company to make informed decisions.

You are required to write a 2,000 words report addressing all the above tasks.

The report has a Module weighting of 60%. [The calculation part of the report is allocated 60% weighting and the theory part is allocated 40% weighting.]

*You MUST demonstrate the application of advanced financial analysis and analytical skills, an ability to weigh up relative advantages of alternative financial management strategies, using persuasive arguments and evidence.

All reports should be written in third person and accurately Harvard referenced within the report and also included in your References.  A Bibliography should also be included.

Your report should include a Contents page.  Each section of the report should be accurately numbered (e.g. 1.0: Introduction; 2.0: Findings; 3.0: Conclusion and 4.0: Recommendations – if required). This is not an essay and therefore, sub-headings should be included throughout the report (e.g. 2.0: Findings: first sub-heading 2.1, second sub-heading 2.2 etc.).

Your report MUST NOT include any unaltered, ‘cut and pasted’ diagrams/tables/charts.  All diagrams, tables and charts must be amended by you to reflect the context of the organisation, sector or case study.  The original diagrams/tables/charts must be sourced (e.g. Adaptation of Multinational Financial Management, Alan Shapiro, 2010). Any information/figures included in the table/chart/diagram must also be sourced. The prevalent use of tables to avoid exceeding the word count will be penalised.
Assessed Learning outcomes:
The assessed learning outcomes for this assignment are as follows:
L1.    apply real options and capital rationing under long term decision making
L2.    recognise and apply the different finance modelling techniques for dealing with project risks and uncertainty
L3.    demonstrate an understanding on the value-based management techniques and appraise its impact on decision making

Assessment Criteria:
The assessment criteria for this assessment are as follows:
•    Enquiry and use of sources
•    Knowledge and understanding of subject matter
•    Critical judgment and analytical ability
•    Written communication
•    Application of technical skills

Plagiarism is an assessment offence and will be treated as a breach of the Academic & Assessment Regulations.
The submitted assessment must be your own work. You must ensure you use your own words. Paraphrasing is still regarded as plagiarism if a candidate fails to acknowledge the source for the ideas being expressed.  The use of quotes, paraphrasing, etc., must be clearly indicated using the Harvard system both within the text and in a separate detailed bibliography. Remember, referencing and the proper use of quotations provides evidence of reading and research. To help you ensure that you work is properly referenced you must submit it through Turnitin before making a final submission.

Appendix (1)

Project A    Project B    Project C    Project D
Outlay Year 0    (500,000)    (400,000)    (120,000)    (1000,000)
Expected Inflow Year 1     350,000     250,000       90,000       900,000

Cash inflow Growth Rate: 5%
Standard Deviation: 1%
Discount rate: 20%
Time: 5 years

Appendix (2)
The products manufactured using the new technology is expected to sell for a price of £300 per unit and price increase rate is 1.5% per year. The company analyst performing the analysis expects the firm can sell 20,000 units in the first year and 0.5% per year increase thereof for next five years. To get into this, business will require the purchase of a £2 million piece of equipment that has a residual or salvage value in five years of £200,000. In addition, the firm expects to have an additional investment of £300,000 in working capital to support the new business. Other pertinent information concerning the business venture is provided in table 1:
Base-case
Unit sales     20,000
Price per unit     £300
Variable cost per unit     (200)
Cash fixed costs per year     (500,000)
Depreciation expense     £360,000
Initial cost of equipment     £2,000,000
Project and equipment life     5 years
Salvage value of equipment     £200,000
Working capital requirement     £300,000
Depreciation method     Straight line
Required rate of return     12%
Tax rate     30%
Variable cost     Increase by 5.5% every year
In addition, estimates for unit sales, selling price, variable cost per unit and fixed cash operating expenses for the base-case, worst-case and best-case are described in table 2:
Table 2: Five years case scenarios
Base-case    Worst-case    Best-case
Unit sales     20,000    15,000    25,000
Price per unit     £300    £250    £330
Variable cost per unit     (200)    (210)    (180)
Cash fixed costs per year     (500,000)    (450,000)    (350,000)
Depreciation expense     £360,000    £360,000    £360,000