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- 1. Applied Managerial EconomicsECON616-1004A-03 Phase 3 Price Elasticity, Net Present Value, and Cash Flows for the Firm Instructor: Edmund Keim Due 11-05-10 By Dorothea Hampton
- 2. Introduction Net Present Value Analysis Used to Discount Cash Flow Positive or Negative Impact on Firm Calculation: Net Present Value Calculation: Certainty Equivalent Flows and NPV Questions for the CEO About Economic Consumptions Economic and Political Risk Involved in Strategy Should This Approach to Expansion be Adopted
- 3. Net Present Value Year Cash Flow PV at 6% 0 ($50,000,000) ($50,000,000) 1 $8,760,000 $8,264,151 2 $13,100,000 $11,658,953 3 $18,060,000 $15,163,524 4 $23,020,000 $18,233,996 5 $26,120,000 $19,518,383 NPV $22,839,008
- 4. Certainty Equivalent Cash Flows Year Cash flow Certainty EQ. % Certainty CF PV 6% 0 ($50,000,000) 100% ($50,000,000) ($50,000,000) 1 $8,760,000 90% $7,884,000 $7,437,736 2 $13,100,000 85% $11,135,000 $9,910,110 3 $18,060,000 80% $14,448,000 $12,130,819 4 $23,020,000 75% $17,265,000 $13,675,497 5 $26,120,000 70% $18,284,00 $13,662,868 NPV $6,817,031
- 5. Economic Assumptions What are the current employment rates in the domestic and foreign regions? How does these rates affect the expansion project? Will labor regulations in Germany and Brazil affect the expansion project? How great is the foreign exchange risk?
- 6. Economic and Political Risk With Strategy/Options to Overcome Interest Rates in Germany and Brazil Long-Term Financing in Brazil Market Trend Increase in Market Share and Price
- 7. Hurdle Rate Certainty Equivalent Cash Flow Year Cash Fl Cert. Eq. Cert. CF PV6% 0 ($50,000,000) 100% ($50,000,000) ($50,000,000) 1 $8,760,000 95% $8,322,000 $7,850,943 2 $13,100,000 90% $11,790,000 $10,493,058 3 $18,060,000 85% $15,351,000 $12,888,996 4 $23,020,000 80% $18,416,000 $14,587,197 5 $26,120,000 75% $19,590,000 $14,638,788 NPV $10,458,982 Year Cash Fl Cert. Eq. Cert. CF PV12% 0 ($50,000,000) 100% ($50,000,000) ($50,000,000) 1 $8,760,000 95% $8,322,000 $7,430,357 2 $13,100,000 90% $11,790,000 $9,398,916 3 $18,060,000 85% $15,351,000 $10,926,539 4 $23,020,000 80% $18,416,000 $11,703,701 5 $26,120,000 75% $19,590,000 $11,115,892 NPV $575,405 Hurdle Rate 12%
- 9. References CTUonline, Applied Managerial Economics, ECON616-1004A-03, November, 2010, Course Materials, Retrieved 11-03-10 Investopedia, Net Present Value, 2010 http://www.investopedia.com/terms/n/npv.asp, Retrieved 11-03-10 The Free Dictionary, Certainty Equivalent, Campbell R. Harvey, 2004 http://financialdictionary.thefreedictionary.com/Certainty+Equivalent Retrieved 11-04-10 CNN Money, Unemployment State by State, October, 2010 http://money.cnn.com/pf/features/lists/state_unemployment/, Retrieved 11-04-10 Business.com, Foreign Exchange Rate Basics, Mark Jenkins, 2010 http://www.business.com/directory/financial_services/investment_banking_and_brokerage/sales_and_trading/for ex/quotes/, Retrieved 11-04-10 Trading Economics, Brazil Interest Rate, 2010 http://www.tradingeconomics.com/Economics/Interest-Rate.aspx?symbol=BRL, Retrieved 11-05-10 Euro Monitor, Home Care in Brazil, 2010 http://www.euromonitor.com/Home_Care_in_Brazil, Retrieved 11-05-10 German Market for Household Cleaning Products, 2010 http://www.thefreelibrary.com/German+Market+for+Household+Cleaning+Products+is+Mature,+but+There...- a0141531308. Retrieved 11-05-10
Editor's Notes
- The CFO, investment bankers, and consultants have been working on various expansion options, and have agreed on an option that will see expansion into five domestic markets and two international markets that include; Chicago, Dallas, Miami, New York, Charlotte, and Germany and Brazil. The CFO has developed the cost and benefits analysis of this expansion option that he has asked me to review. I will use the present value analysis to discount the cash flows, explain the impact of the cash flow on the firm to determine if it will be negative or positive, and calculate the certainty equivalent cash flows and the net present value to the certainty equivalent cash flows. There will be questions for the CFO regarding economic assumption derived from the analysis of this option. We will also discuss some of the economic and political risks that could affect CPI’s expansion option with this strategy and whether or not this approach to expansion should be adopted or passed up, (Course Material, 2010).
- The net present value is used in capital budgeting to analyze the profitability of the expansion project for CPI. The net present value (NPV) is discounted by taking the present value of all cash inflows and subtracting the present value of all cash outflows, (Investopedia, 2010). In order to perform this calculation, there must be a discount rate, which is the rate of interest used to evaluate this expansion project. The discount rate represents the cost of capital which will be used to discount the cash flows for a period of five years, to determine what the net present value of the cash flows will be. Looking at the figures above, the cash flows are discounted at 6% cost of capital, then added together. The value $22,839,008 is the amount that represents the total present value of the cash for the project. The net present value has a positive value. A positive net present value means that the project will cover the cost of capital plus possibly yield an increase on investment. If the cash inflows were lower to the point that the discounted cash flow was negative, the project would not be a good investment because it would not yield a return; instead, the project would cost the investor by reducing the investment capital. If the net present value was zero, the cost of capital would be covered but the investment would not yield any increase above that amount or decrease from that amount.
- The certainty equivalents are used to evaluate the risk of the investment. The certainty equivalent cash flows is the amount of money accepted today that is risk free for a chance to receive a higher amount; however, it is uncertain a higher amount will be received, (Harvey, 2004). This discount method considers the risk involved when calculating by adjusting the cash flows with a risk factor. Just to give an example to clarify just how certainty equivalent cash flow works. Let us say you invested a certain amount into this expansion project; well, the certainty cash flow is the minimum amount that you would accept to forgo this opportunity to participate in this expansion project, without certainty of the outcome. In the above example of the grid, the calculation for certainty equivalent cash flows is performed by taking the cash flow then multiplying it by the certainty equivalent percentage coefficient to derive at the certainty cash flows to be discounted at 6% to get the present value of the certainty cash flow. The decision maker of CPI have established the coefficients in which the risks are adjusted. The risk adjustment factor assumes a value between zero and one, which varies with the risk. A lower risk adjustment rate will be used if the risk is anticipated to be low. These coefficients represents the decision makers confidence in obtaining a certain cash flow for the project in a specified time frame. To get a better understanding, let’s say we have estimated a cash flow of $20,000 for the upcoming year, but the investor feels that only 80% of that amount is certain, then the certainty equivalent coefficient will be 0.8; therefore, the investor considers only $16,000 as the certain cash flow.
- The expansion project for CPI is expected to expand to five domestic regions and two international regions. The domestic regions are Chicago, Dallas, Miami, New York and Charlotte. The unemployment rate for Chicago is currently 10.1%, Dallas 8.6%, Miami 7.5%, New York 10%, and Charlotte 11.1%, (CNN, 2010). The unemployment rate in the domestic regions can have a negative impact on the expansion project for CPI. First, let me explain what I mean by that statement. The household sector contributes to the amount of disposable income available for consumption, and the higher the unemployment rate in a domestic region, decreases the amount of disposable income available for consumption. If the consumer is experiencing a decrease in income, they are less likely to invest in products that are costly, yet the consume will look for the same product for a less costly price. The current unemployment rates for Germany and Brazil are consecutively 8.2% and 7.9%. Even though the unemployment rates in Germany and Brazil are lower than the rates in the domestic regions of the U.S., there is still the absence of disposable income to consider due to an economic slump. We must consider what are the labor regulations like for these foreign regions, and how does these regulations affect the expansion project? The labor law for Germany and Brazil are very strict and dismissing employees in these foreign countries can become quite costly; thus, impacting the operating income. The final question we will explore is “will there be a foreign exchange risk; if so, how great is this risk? With most opportunities there is an associated risk. In Germany the dollar is called the Euro, and Brazil the dollar is called the Real. The Euro has been more stable than the Real, which have seen significant currency fluctuations in the past years. It is important to understand the factors that influence the foreign exchange rate. Once CPI know what drives the rates to rise or fall, CPI can then watch the market for the trends, (Jenkins, 2010).
- One of the main economic indicators used for this part of the presentation is the interest rates. Let’s first start with the interest rate in Germany, where the long term interest rate is down to 2.42% as of the third quarter of this year. The interest rates in Germany is considerably less than the whopping 10.75% in Brazil. The Central Bank of Brazil’s Monetary Policy Committee has bench marked the interest rates, as they were last reported, (Trading Economics, 2010). Considering the expansion project, it would not be financially feasible for CPI to receive long term financing in this region. In addition to the interest rates in Brazil being more than triple to that of Germany, there is also other considerations. Not only is the interest rates in Brazil astronomical, there is also the cost associated with establishing a business where the tariff is high. There are some advantages to doing business in Brazil; that is, the labor is cheaper. A strategic option that comes to mind for CPI is to avoid financing in this region and capitalize on the cheap labor. It would be strategically sound to consider production in this region opposed to importation and distribution because of the cheap labor. Where as, if CPI considered financing in Germany it would not be so bad, as the interest rates for long term financing is considerably lower. However, the income range in German is higher than that of Brazil’s and the tariff is also high. In the case of Germany, it may be more advantageous to import and distribute rather than establishing a plant for production. The market trend in Brazil reveals that the market for home care products has been on an increase, as the low income household starts to stimulate economic growth. Not only did these consumers consume higher volumes of the products that they had already been purchasing, such as laundry detergents, they also started to buy other types that they had not been able to afford before, like multi-purpose cleaners and household antiseptics/disinfectants. Consequently, the retail volume growth has been stimulated by the increasing household penetration rates of home care items, (Euro Monitor, 2010). The market trend in Germany for the market of household products are noted to be mature, but offers an opportunity to increase market penetration. At this point there are many option available to CPI for the expansion project. In Germany, where there is room to expand in the market, CPI has an opportunity to increase market shares and through advertising. This is a plausible opportunity to increase the shareholders’ wealth.
- CPI is adamant about this expansion project, and above is a projection of what the hurdle rate for this expansion project would look like for a competitive market, such as Germany’s. If Germany is highly competitive and the cost of labor is relatively high , then CPI may consider reducing product cost, which will cause a negative impact on profitability. Looking at the figures above, again considering the high cost of labor for this region, can also result in a cash contribution loss. The net present value of the discounted certainty equivalent cash flow at 6% and 12%, still renders a cash flow that has a positive outcome. If the current interest rates were to double, CPI would still be able to render a positive cash flow.
- Not to make small of the fact that there will be political and economic risks associated with expanding in foreign regions; the opportunity is worth it when the advantages outweigh the risks. These risks may include, but are not limited to the possibility that investors could potentially lose money or make less money than expected due to political decisions, conditions, or even events occurring in that country or emerging markets in which investors are investing at the time. Some of the specific problems that could spawn include government instability or currency inconvertibility, maybe even nationalization. Which ever is the case, these factors could pose a problem at any time. However, the net present value of this expansion project on a non cash equivalent basis is $22.8 million, adjusting for risk, the certainty equivalent cash flow is $10.4 million. The figures are quite positive. If the hurdle rate were to double with an adjustment for risk, the net present value would still be positive. In order to make an accurate decision about the economic benefit in expanding into these foreign and domestic regions, a cost benefit analysis would have to be done on each of these regions separately. This would provide more accurate information for an informed decision to be based on. However, from my professional opinion, I would recommend accepting this project because the project is projected to yield a high return on investment.