Financial Management

Financial Management Budgeting
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Acknowledgement
First our sincere gratitude goes to Mr. Sandun Fernando, our lecturer for Financial Management module. It is with pleasure that we are grateful to our dear sir for the constant support, guidance & also for the encouragement provided to us. Also our thank goes to our project work lecturers, Mrs. Dilani Abeynayake & Miss. H. Chandanie for their great support in completing this task course work successfully. We would also like to thank everyone at the Department of Building Economics for helping us to complete the course work within the submission date. We would also like to remind the support given by the staff at the Computer Laboratory of the Department of Building Economics, Resource Room and library. At last but not least we also like to remind the support given by the fellow batch mates studying Quantity Surveying and Facilities Management dedicating their valuable time.
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Table of Contents
Financial Management Capital Budgeting................i
Introduction..........................................................................................................................................1 Financial Management Capital Budgeting...............1
1.0 Link Engineering............................................................................................................................3 1.1 Back Ground...............................................................................................................................3 1.2 Vision..........................................................................................................................................3 1.4 Policy on quality.........................................................................................................................4 1.5 Investments.................................................................................................................................4 1.5.1 Invested Projects..................................................................................................................4 1.5.2 New Investment Opportunities............................................................................................4 2.0 Capital Budgeting Techniques.......................................................................................................5 2.1 Profitability Index.......................................................................................................................5 2.1.1 Introduction..........................................................................................................................5 2.1.2 Applications of Profitability Index.......................................................................................7 2.1.3 Advantages and Disadvantages of Profitability Index Method ...........................................8 2.2 Net Present Value.......................................................................................................................9 2.2.1 Introduction..........................................................................................................................9 2.2.2 NPV in decision making....................................................................................................10 2.2.3 Applications of Net Present Value.....................................................................................11 2.2.4 Advantages and Disadvantages of Net Present Value Method..........................................11 2.3 Internal Rate of Return.............................................................................................................13 2.3.1 Introduction........................................................................................................................13 2.3.2 Applications of Internal Rate of Return.............................................................................15 2.3.3 Advantages and Disadvantages of IRR method.................................................................16 Department of Building Economics ii
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3.0 Recommendations........................................................................................................................19 3.1 Report........................................................................................................................................19 3.2 Proposed Techniques................................................................................................................20 3.2.1 Payback Period Method.....................................................................................................20 3.2.2 Real Option Analysis.........................................................................................................21 Conclusions........................................................................................................................................25 References..........................................................................................................................................26
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Introduction
Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented. Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time. In contrast putting money into something with an expectation of gain without thorough analysis, without security of principal, and without security of return is speculation or gambling. Meantime it is sensible to mention about why investment decisions are that much important to any type of business. It is simply because of the following reasons. Influence the firms growth in the long run
The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. A firms decision to invest in long term assets has decisive influence on the rate and direction of its growth. Affect the risk of the firm
A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm. Irreversible, or reversible at substantial loss
Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmers very carefully and make an advance arrangement for procuring finances internally or externally. Among the most difficult decisions to make
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Most Investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Firms invest in capital projects to expand production to meet anticipated demand or to modernize production equipment to reduce costs. Firms also invest in capital projects for many noneconomic reasons, such as installing pollution control equipment, converting to a human resources database to meet some government regulations, or satisfying nonmarket public demands. Information systems are considered long-term capital investment projects. Key budgeting models which are used to evaluate capital projects includes: The payback method The accounting rate of return on investment (ROI) The net present value The cost-benefit ratio The profitability index The internal rate of return (IRR)
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1.0 Link Engineering

1.1 Back Ground
Link Engineering is a construction company incorporated in 1980 by a group of professional Sri Lankan engineers. Having successfully completed several major buildings such as Kandalama Hotel which has been of significant importance to both the company and the country, Link Engineering subsequently diversified into highway and bridge construction, water supply, irrigation, land reclamation and pre engineered buildings. Presently Link Engineering undertakes to complete project from the investigation planning and design stages to construction and commissioning under a single contract or turnkey basis and also offers specialized services such as Electrical and mechanical services Aluminum fabrication Floor finishes Interior decorating Manufacture of kitchen pantry systems & exclusive furniture Landscaping
1.2 Vision
To constantly realign, reposition and reinvent ourselves embracing highest levels of professional expertise, new technology and change thereby consistently striving to exceed the returns of comparable organizations and be at the forefront of the industry.
1.3 Mission
To work cohesively to achieve exceptional standards of quality in all our undertakings to the satisfaction of all stakeholders through the participation of highly qualified professional staff assisted by an experienced, competent and dedicated work force. Department of Building Economics 3
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1.4 Policy on quality

The company undertakes to establish and maintain quality systems which will satisfy the specified requirement and needs of our clients with the goodwill of our supplies and with the total participation of our trained employees who are delegated with authority and responsibility for the achievement of total quality management.
1.5 Investments
As a construction companies normally work on a small percentage of fixed assets, capital
investment opportunities available for Link Engineering is very low. But getting started as a construction company, Link Engineering through its investment has tried to expand its business over other sectors such as ayurvedic medical production, carbonized stationary, soya based food production and entertainment. But unfortunately most of those investments have turned out to be failures. Therefore it would be interesting to find out the capital budgeting techniques which proved them to be successful.
1.5.1 Invested Projects

Head Office Building at 338, T.B. Jayah Mawatha, Colombo 10. Establishment of link natural products in 1982. Ware House at Dompe. Establishment of Bieco link carbons in 1987. Establishment of Plenty foods 1996. Establishment of Link recreation (Millanium Park) in 1997.
1.5.2 New Investment Opportunities

Establishment of a ready mix concrete plant at Dompe.
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2.0 Capital Budgeting Techniques

Capital budgeting techniques are a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. Inorder to do that Capital Budgeting Techniques are used.
2.1 Profitability Index

2.1.1 Introduction
Profitability index (PI) is a capital budget technique lying under the Discounted Cash Flow methods and also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows quantifying the amount of value created per unit of investment made by the investor. The ratio is calculated as follows:
Present Value of future cash flows Profitability Index = Initial Investment
Present Value of Cash Inflows Profitability Index = Department of Building Economics Present Value of Cash Outflows 5
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As a another definition, Profitability Index is a variation of NPV, comparing discounted future cash flows against the initial outlay in the form of a ratio. This ratio compares the magnitude of the future cash flows against the initial investment required to initiate the project. This is useful for comparing the profitability of projects of different sizes, where NPV might favor a larger project, but the smaller one might be more profitable. Profitability index, explained as a measure of whether or not a proposed project will be profitable and simple or complicated depending on the scope of the project in question. If the money expected to be generated from the project exceeds the costs required to fund the project, then it will be a profitable investment. The profitability index is one of several methods used to measure and quantify the attractiveness of a proposed investment. Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the projects Present Value is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. If Profit Index is equal to1, the projects benefits are expected to equal its costs. If Profit Index is greater than 1, then project should be accepted. If Profit Index is less than 1, then reject the project.
If the profitability index is one, the projects cash outflows are expected to equal its cash inflows. If the profitability index is any number less than one, the projects cash outflows are expected to exceed the projects cash inflows. In other words, it is a bad investment. Generally speaking, a company would want to reject any project with a profitability index of less than one because investing in that project would be a money-losing venture. If the profitability index is any number greater than one, that means the projects cash inflows are expected to exceed the projects cash outflows. In other words, it is a good investment. Generally speaking, a company would want to accept any project with a profitability index greater than one because investing in that project would be a profitable venture. A higher number means a more attractive investment. For example, a project with a profitability index of 1.3 would be a more attractive investment than a project with a profitability index of 1.2. Department of Building Economics 6
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2.1.2 Applications of Profitability Index

Profitability Index is a preferred capital budgeting technique to Link Engineering as it clearly indicates an idea on the profit which is to be generated. Therefore other than for capital investment decisions, Profitability Index is also used in construction project investment decisions. 2.1.2.1 Head Office Building Investment Up to mid 1980s Link Engineering carried out their business in rented out buildings and they came up with an idea to purchase a building permanently. Although there was no visible future cash inflow on this investment, there was a clear saving on the rentals. Therefore they had considered those savings as cash inflows and have come up with a Profitability Index around 1.37 at that time. They have proceeded with the investment, but it has proved to be a failure. 2.1.2.2 Establishment of Link natural products, Plenty foods and Link recreation The above establishments were of course not aligning with construction. But unfortunately it was the Link Engineerings capital which was used in financing the above establishments. According to Link Engineering, Profitability Indexes have been in favour of establishing the above. But Link Engineering could not bear the huge initial investment made on those long term investments. Therefore all of the establishments, except 10% of Plenty foods had to be sold out by 2000. 2.1.2.3 Ware House Investment The Profitability Index for Ware House has been 1.14, just above 1. But considering the cost savings on out sourcing timber work, aluminium work, and machinery repair work, ect. Link Engineering has decided to invest on the ware house. Up to present nothing seems wrong about the investment decision. 2.1.2.4 Ready Mix Concrete Plant Investment As per the NPV calculation in the following section it is evident that present value of expected income from the project is to be Rs.39,090,000.00 and the initial cash outflow would be Rs.12, 000,000.00 to build. Profitability Index = PV of Cash Inflows / PV of Cash Outflows Profitability Index = Rs.39,090,000/ Rs.12,000,000 = 3.2575
The profitability index of the Ready Mix Concrete Plant is above 1. Therefore the investment is rectified. Department of Building Economics 7
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2.1.3 Advantages and Disadvantages of Profitability Index Method

2.1.3.1 Advantages Tells whether an investment increases the firm's value Considers all cash flows of the project Considers the time value of money Considers the risk of future cash flows (through the cost of capital) Useful in ranking and selecting projects when capital is rationed Evaluates multiple projects
2.1.3.2 Disadvantages Requires an estimate of the cost of capital in order to calculate the profitability index May not give the correct decision when used to compare mutually exclusive projects Only used for divisible projects Strategic value of projects are not considered. (Only figures are dealt with not long term not short term) Limited use when protect have differing cash flow pattern. (Only limited to investment with major cash at the beginning) Absolute NPV vale is ignored; smaller projects receive more favorable treatment (the equation treats all project as equally important. As it is a percentage, it does not give a clear idea on amounts.
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2.2 Net Present Value

2.2.1 Introduction
NPV is one of a tool discussed under discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise projects. This method is used for capital budgeting, and widely throughout economics, finance, and accounting. It measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. In some situations all future cash flows are incoming and the only outflow of cash is the purchase price, in that circumstance the NPV is the present value of future cash flows minus the purchase price. In simple terms net present value is a method of calculating the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time. Steps which should be followed in calculation of NPV 1. 2. 3. Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flow. Present value of cash flows should be calculated using the opportunity cost of capital as the
discount rate. 4. NPV should be found out by subtracting present value of cash outflows from present value 9
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Formula for calculating net present value C1 NPV = (1 + k)1 NPV = Ct (1 + k) t C0 + (1 + k)2 C2 + (1 + k)3 C3 + Cn + (1 + k)n C0 -
Where: t k C1 C0 - The time of the cash flow - The opportunity cost of capital - Net cash flows in year 1, 2, 3,, n - The initial cost of the investment
2.2.2 NPV in decision making

The rationale for the NPV method is straightforward. NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if its net present value is positive then it can be accepted and reject if NPV less than zero value. . If a project has a positive NPV, then it is generating more cash than is needed to service its debt and to provide the required return to shareholders and this excess cash accrues solely to the firms stockholders. Therefore, if a firm takes on a project with a positive NPV, the position of the stockholders is improved. In addition to that NPV can be used to select between mutually exclusive projects in one which generates higher value for NPV. If there is situation where one project should be selected out of several projects, then projects can be ranked in order of net present values; that is, first rank will be given to the project on the basis of highest positive net present value. An NPV of zero indicates that the projects cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capital. There is also a direct relationship between NPV and EVA (economic value added)NPV is equal to the present value of the projects future EVAs. Therefore, accepting positive NPV projects should result in a positive EVA and a Department of Building Economics 10
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positive MVA (market value added, or the excess of the firms market value over its book value). So, a reward system that compensates managers for producing positive EVA will lead to the use of NPV for making capital budgeting decisions.
2.2.3 Applications of Net Present Value

Net Present Value has also been used to decide on the investments mentioned in Profitability Index section. But only the investment on Ready Mix Concrete Plant would be discussed here. 2.2.3.1 Ready Mix Concrete Plant The NPV of the ready mix concrete plant has been calculated to be Rs. 27.09Mn which encourages Link Engineering to proceed with the investment. The calculation is drafted below.
Discount Rate (As per 30/06/2011): Year Net Cash Flow of Concrete Plant (RS. Mn) Discount Factor NPV 0 -12 1.00 27.09 1 8 0.88 13.40% (This rate is a main result of the high level of debt) 2 8 0.78 3 8 0.69 4 8 0.60 5 8 0.53 6 8 0.47 7 8 0.41 8 8 0.37 9 8 0.32 10 8 0.28
2.2.4 Advantages and Disadvantages of Net Present Value Method

2.2.4.1 Advantages Consider all cash flows
In calculating the value of NPV, it considers all the inflows and out flows, but in payback method it considers only to the point where the cash inflows exceed the initial cash outlay. True measure of profitability
The NPV method is entirely based on estimated cash flows and the discount rate rather than any arbitrary assumptions or subjective considerations. Based on the concept of the time.
Most important concept used in this method in evaluating projects based the time value of money. So by considering time value of money, investor can come into a good decision. Department of Building Economics 11
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Satisfies the value additive principle
Value additive principle is that NPV (A + B) = NPV (A) + NPV (B). It implies that if the NPV of each individual project is known then the value of the firm increases by the summation of NPV in all individual projects. The value additively is an important property of an investment criterion because it means that each project can be evaluated, independent of others, on its own merit. Consistent with the shareholders wealth maximization and indicates whether a proposed project will yield the investors required rate of return
2.2.4.2 Disadvantages Requires estimates of cash flows which is a tedious task
In actual working it is difficult to forecast the expected cash flows of an investment. Therefore most of the time cash inflows and outflows are calculated by the experience of the people who are involved in analyzing the capital budget. But there is a high possibility in making wrong assumptions. Requires computation of the opportunity cost of capital which poses practical difficulties.
As mentioned above it is difficult to predict a correct value for the opportunity cost of capital. Sensitive to discount rates.
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2.3 Internal Rate of Return

2.3.1 Introduction
This is the most common discounting method of capital budgeting and also IRR is a popular measure used in capital budgeting. The IRR is a measure of the rate of the profitability. By definition, IRR is a discount rate that makes the present value of cash flows equal to the initial investment. The IRR is an alternative measure for evaluating projects. IRR method concerns about magnitude and timing of cash flows. Other terms used to describe the IRR method are yield of investment, marginal efficiency of capital, rate of return over cost, time adjust rate of return. IRR is the calculated rate of return at which the NPV will be equal to zero. In project evaluation this rate has to be equal or greater than the required rate of return for the project to be acceptable. When choosing among mutual exclusive project, the project with the highest IRR should be selected as long as the IRR is greater than the cost of capital. In simple term the IRR is a discount rate that makes NPV equal to zero. The rate below which projects are rejected is called the cutoff rate, the target rate, or the required rate of return. Firms determine their cutoff rates by the cost of financing and riskiness of the project. Next they predict future cash flows and calculate the IRR. If the calculated IRR exceed the cutoff rate, the project is added to the list of recommended investment. IRR is calculated by manually trial and error, or by special routine in computer based spreadsheet goal seeking command. Department of Building Economics 13
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The formula is used to calculate NPV as follows,
NPV =
CFt n t = 0 (1 + DF) t
When the NPV = 0,
NPV = 0 =
CFt n t = 0 (1 + IRR ) t
t = Nr of years
CF = Cash flow of tth year. (Income of the tth year) DF = Discount rate NPV
IRR
; NPV = 0
Discount Factor
The IRR calculations are done manually it cannot continue for the project which have long time period such as more than 5 years. Therefore to avoid that problem following formula has been developed using cotangentgeometry applying above graph.
IRR =
Discount rate which give positive NPV
Discount rate which Positive NPV value give negative NPV + Positive NPV value -
Discount rate which give positive NPV
Negative NPV value
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2.3.2 Applications of Internal Rate of Return

Internal Rate of Return has also been used to decide on the investments mentioned in Profitability Index section. But only the investment on Ready Mix Concrete Plant would be discussed here. 2.3.2.1 Ready Mix Concrete Plant The Internal Rate of Return of the Plant has been calculated as 37.96% which is higher than Link Engineerings discount rate. Therefore the investment seems reasonable. The calculation is drafted below.
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Cash flow of RCC Plant (Rs. Mn.) IRR Calculation Year Cash flow Discount factor @ 10% discount factor Present value Net Present Value Discount factor @ 25% discount factor Present value Net Present Value
-20
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
10%
0 -20 1.00 -20.00
1 8 0.91 6.82
2 8 0.83 6.20
3 8 0.75 5.63
4 8
5 8
6 8 0.56 4.23
7 8 0.51 3.85
8 8 0.47 3.50
9 8 0.42 3.18
10 8 0.39 2.89
Discount rate
0.68 0.62 5.12 4.66
10%
26.08
1.00 -20.00
0.71 5.36
0.51 3.83
0.36 2.73
0.26 0.19 1.95 1.39
0.13 1.00
0.09 0.71
0.07 0.51
0.05 0.36
0.03 0.26
40%
-1.90
According to above mentionmanual calculation formular IRR = 10% + 26.08 ( ( 40% 26.08 10% ) -1.9 )
IRR =
37.96%
2.3.3 Advantages and Disadvantages of IRR method

2.3.3.1 Advantages Perfect Use of Time Value of Money Theory
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Time value of money means interest and it should high because we are sacrifice of money for specific time. IRR is nothing but shows high interest rate which we expect from our investment. So, we can say, IRR is the perfect use of time value of money theory
All Cash Flows are Equally Important
It is good method of capital budgeting in which give equal importance to all the cash flows not earlier or later. It create relation with different rate and want to know where is present value of cash inflow is equal to present value of cash outflow. Uniform Ranking
There is no base for selecting any particular rate in IRR. IRR can be used to rank different prospective projects and the project with the highest IRR would be considered the best. Maximum profitability of Shareholder
If there is only project which have to select, if its IRR is checked and it is higher than its cut off rate, then it will give maximum profitability to shareholder. Not Need to Calculate Cost of Capital
In this method, we need not to calculate cost of capital because without calculating cost of capital, we can check the profitability capability of any project. True measure of profitability
This method tells whether an investment increases the firms value and the project is worth or not to the firm. 2.3.3.2 Disadvantages To understand IRR is difficult
It is difficult to understand it because many people cannot understand why are calculating different rate in it and it becomes more difficult when real value of IRR will be two experimental rate because of not equalize present value of cash inflow with present value of cash outflow. Estimate cash flows 17
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Requires an estimate of the cash flows in order to calculate IRR and make a decision. Therefore prediction can be wrong, if the project has long time period. And also Cannot be used in situations in which the sign of the cash flows of a project change more than once during the project's life.
Unrealistic Assumption
For calculating IRR create one assumption. That think invest out money on this IRR, after receiving profit, can easily reinvest our investments profit on same IRR. This assumption seems to be unrealistic. Not Helpful for comparing two mutually exclusive investment
IRR is not good for comparing two mutual exclusive projects.May not give the value-maximizing decision when used to compare mutually exclusive projects Doesnt consider the cost of ccapital
IRR does not take into account of the cost of capital, thus it should not be used to compare projects of different duration. It is difficult to calculate
The IRR could be difficult to find, it want to calculate it by using trial and error method.
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3.0 Recommendations
After studying the capital budgeting techniques used by Link Engineering, following recommendations were suggested for better budgeting.
3.1 Report
By going through the capital budgeting decisions made by Link Engineering, one can clearly understand that many decisions have ended up in a failure. Several reasons could be brought forward for those failures. First of all it is evident that the techniques used are bias towards one part. They all belong to discounting method. For example Link has not used any method to evaluate the time factor in the cash flows. Another main reason behind those failures is the ignorance of time duration in which the initial capital investment could be recovered. If we take the Head Office Building investment this situation is clearly evident. There Link Engineering has invested considerably large amount of their fixed assets on the building which only saves them the rental in the long run. At the end Link had to sell the building back to overcome the struggle in the cash flows. Therefore the period taken to recover the initial investment shall not be disregarded. If we consider the investments made on establishment of Link Natural Products, Plenty Foods and Link Recreation (Millennium Park), the problem is, it is the capital of Link Engineering which was invested in those separate sectors. Of course there would have been a good return on those investments. It is clear as currently those are doing well as separate companies. But the problem was that those were long term investments. Therefore Link could not go on with their normal work managing or surviving with the available capital. Therefore it is more a failure in management strategy than in the capital budgeting technique. Therefore it is important to evaluate whether the
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current business would survive with the remaining capital before investing a part of capital in a new business.
3.2 Proposed Techniques

In order to overcome some of the issues identified in the Report, the following capital budgeting techniques are suggested to be used by Link Engineering.
3.2.1 Payback Period Method

Payback period method could be used to evaluate the time period which would be needed to recover the initial investment, which has been a big issue for Link Engineering. 3.2.1.1 Description The payback is another method to evaluate an investment project. The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is some times referred to as" the time that it takes for an investment to pay for itself." The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period. Payback period = Investment required Net annual cash inflow
The payback method is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another. As an example X company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs Rs.15, 000.00 and will reduce operating cost by Rs.5, 000.00 per year. Machine B costs only Rs.12, 000.00 but will also reduce operating costs by Rs.5, 000.00 per year. Machine A payback period = Rs.15, 000.00 / Rs.5, 000.00 = 3.0 years Machine B payback period = Rs.12, 000.00 / Rs.5, 000.00 = 2.4 years Department of Building Economics 20
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To illustrate, consider again the two machines used in the example above. Since machine B has a shorter payback period than machine A, it appears that machine B is more desirable than machine A. But if we add one more piece of information, this illusion quickly disappears. Machine A has a project 10-years life, and machine B has a projected 5 years life. It would take two purchases of machine B to provide the same length of service as would be provided by a single purchase of machine A. Under these circumstances, machine A would be a much better investment than machine B, even though machine B has a shorter payback period. Unfortunately, the payback method has no inherent mechanism for highlighting differences in useful life between investments. Such differences can be very important, and relying on payback alone may result in incorrect decisions. 3.2.1.2 Advantages and Disadvantages of Payback Period Method Advantages Simple to compute Provides some information on the risk of the investment Provides a crude measure of liquidity
Disadvantages No concrete decision criteria to indicate whether an investment increases the firm's value Ignores cash flows beyond the payback period Ignores the time value of money Ignores the risk of future cash flows
3.2.2 Real Option Analysis

3.2.2.1 Description Real options valuation, also often termed Real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself is the right but not the obligation to undertake some business decision; typically the option to make, abandon, expand, or Department of Building Economics 21
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contract a capital investment. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively. Comparison with standard techniques ROV is often contrasted with more standard techniques of capital budgeting, such as discounted cash flow (DCF) analysis / net present value (NPV).
Using a DCF model, only the most likely or representative outcomes are modeled, and the "flexibility" available to management is "ignored"; see Valuing flexibility under Corporate finance. The NPV framework (implicitly) assumes that management is "passive" with regard to their Capital Investment once committed. Analysts usually account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers
By contrast, ROV assumes that management is "active" and can modify the project as necessary. ROV models consider "all" future outcomes and management's response to these contingent scenarios. Because management responds to each outcome.
Valuation From the above it is clear that there is an analog between the modeling of real options and financial options. However, ROV is distinguished from these approaches in that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, and management's ability to respond to the evolution of these parameters. Valuation inputs Given the similarity in valuation approach, the inputs required for modeling the real option corresponds, generically, to those required for a financial option valuation. The specific application, though, is as follows: 1. The option's underlying is the project in question - it is modeled in terms of

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2. Option characteristics

Strike price Option term Option style. Management's ability to respond to changes in value is modeled at
3.
each decision point as a series of options:

the option to contract the project (an American styled put option); the option to abandon the project (also an American put); the option to expand or extend the project (both American styled call options); Switching options, composite options or rainbow options which may also apply to the project.
Valuation methods The valuation methods usually employed are adapted from techniques developed for valuing financial options. Note though that, in general, while most "real" problems allow for American style exercise at any point (many points) in the project's life and are impacted by multiple underlying variables, the standard methods are limited either with regard to dimensionality, to early exercise, or to both. In selecting a model, therefore, analysts must make a tradeoff between these considerations; see Option (finance): Model implementation. The model must also be flexible enough to allow for the relevant decision rule to be coded appropriately at each decision point. The most commonly employed are Closed form solutions often modifications to Black Scholes and binomial lattices and also Specialized Monte Carlo Methods have also been developed. Various other methods, aimed mainly at practitioners, have been developed for real option valuation Limitations The relevance of Real options, even as a thought framework, may be limited due to organizational and / or technical considerations. When the framework is employed, therefore, Department of Building Economics 23
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the analyst must first ensure that ROV is relevant to the project in question. These considerations are as below. Organizational considerations Real options are particularly important for businesses with a few key characteristics, and may be less relevant otherwise. At the same time the market in question must be one where "change is most evident", and the "source, trends and evolution" in product demand and supply, create the volatility and contingencies discussed above.
In overview: 1. The business must be positioned such that it has appropriate information flow, and opportunities to act. 2. Management must understand options, be able to identify and create them, and appropriately exercise them 3. The financial position of the business must be such that it has the ability to fund the project as required. Management must also have appropriate access to this capital. Technical considerations Limitations as to the use of these models arise due to the contrast between Real Options and financial options, for which these were originally developed. The main difference is that the underlying is often not tradable - e.g. the factory owner cannot easily sell the factory upon which he has the option. Additionally, the real option itself may also not be tradable - e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision (some real options, however, can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future). Even where a market exists - for the underlying or for the option - in most cases there is limited (or no) market liquidity. 3.2.2.2 Difficulties in Real Option Analysis 1. As above, data issues arise as far as estimating key model inputs. Here, since the value or price of the underlying cannot be observed, there will always be some uncertainty as to its value (i.e. spot price) and volatility. Department of Building Economics 24
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2. It is often difficult to capture the rules relating to exercise and consequent actions by management: Some real options are proprietary while others are shared. Further, a project may have a portfolio of embedded real options, some of which may be mutually exclusive.
Conclusions
From the beginning of this course work the focus was on capital budgeting techniques. The aim was to find out the techniques actually practiced in the real world. To overcome this task, Link Engineering, a facility belong to construction industry was selected. The selection was riskier as construction firms normally do not go for large amount of long term capital investment. But on the other hand Link Engineering had undertaken many investments in several sectors. It was evident that Link has prominently used Net Present Value, Internal Rate of Return and Profitability Index methods in making investment decisions. In the process of calculating the NPV it was noted that Link is having a relatively higher cost of capital as Link is running on large amount of debt recently. It was some sort of a surprise to find that many investments which were on the positive side on capital budgeting technique calculations, have end up in failures. After going through thoroughly the cause was identified. The reason was the ignorance of time factor of cash flows. In another words, the time duration which take to recover the initial investment was not considered. All the factors including Net Present Value, Internal Rate of Return and Profitability Index do not give a clear picture on this time factor. It considered better to use a capital budgeting technique such as Payback Period Method which considers the time factor of the cash flows. This situation established the fact that the result of only one technique or similar techniques would be misleading and an investment decision shall never be made on results like those. Department of Building Economics 25
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During the course work another fact was identified that one shall be very cautious in investing a companys capital on a different sector so that the main business could survive properly. After studying the capital budgeting techniques used by Link Engineering and identifying issues of them, several other methods such as Payback Method and Real Option Analysis which could be effectively used in making capital investments overcoming above issues was suggested to be used. After all, the course work was a overall success in understanding the real situation of capital budgeting at the real context and identifying the issues of them.
References
Belkaui, A. R., 2001. Evaluating capital projects. Greenwood: USA. Chandra, P., 1987. Projects preparation, appraisal, budgeting and implementation. 3rd ed. New Delhi: Tata McGraw-Hill publishing company limited. Gtze, U., Northcott, D., and Schuster, P., 2008. Investment Appraisal: Methods and Models. Springer :Newyork. Groppelli, A. A., andNikbakht, E., 2006. Finance. 5th ed. Barrons educational series:Newyork. Pandey, I.M., 2011. Financial Management. 10th ed. New Delhi: Vikas publishing house pvt ltd. Paramasivan, M. and Subramanian, T.,2009. Financial Management. New Delhi:
New age international (p) limited, publishers Schwalbe, K., 2007. Information technology project management. 4th ed. India: Thomson course technology.
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