3) Financial management: Investment analysis

Marginal costs

= the cost of producing one more unit of a good or service

• Key decision making in the short run

  • Produce as long as marginal revenue (price) > marginal cost

  • In the short run: disregards fixed of sunk costs

Opportunity costs

= the “cost” incurred by not enjoying the benefit associated with the best alternative choice

Example

A factory has a production line where product ‘A’ is produced, how to assess the economic feasibility on innovative product ‘B’ on the same production line?

• Marginal cost = cost_a, cost_b

• Revenues = price_a,price_b

Produce product B if?

A. price_b > cost_b

B. price_b > cost_b + price_a - cost_a

C. cost_a > cost_b

Answer = B, because the gain of B has to be bigger to replace A

Investment analysis

• NPV = Net Present Value = The present value of net cashflows

• Ct = cash flow in period t

• C_0 = investment

• r = discunt rate = opportunity cost of capital

Internal rate of return

• r that sets NPV = 0

Difference in application between public and private

• Public perspective = enconomic cost benefit analysis

• Privat perspective = financial cost benefit analysis

Applications

• Labour

  • Private = cost of labour that project needs to pay

  • Public = labour cost could be discarded when it considers increasing employment and thus decreasing unemployments benefits

• Subsidies

  • Private = part of income

  • Public = not be considered or part of costs

Consumer or producer surplus

Spill over effect

• Can be considered in public analysis

  • Direct investments in related industries

  • Increased spending by beneficiaries

  • Learning => competitiveness can attract more investments

  • Non monetary benefits: biodiversity

Risk and uncertainty in investment analysis

Risk	Uncertainty
all potential outcomes and their likelihood of occurences are known to the decision maker	either the outcomes and/or their probabilities of occurrences are unknown to the decision maker

Investment flexibility: real options

= the flexibility to alter the course of action in a real assets decision, depending on future developments

• Company’s value assessment requires that real options be considered and properly evaluated

• Standard discounted cash flow approaches ignore a key source of value (real options) and therefore undervalue most capital investments

Sources real option value

• Created or purchased: patents, production flexibility, rights to develop land or natural resources

• Real options can evolve naturally in a company due to existing competencies in a firm: research and development, advertising, technical expertise

Examples

• Growth options

  • R & D

  • Land

  • Natural resource exploration

  • Staged investments; expansion options

  • Follow-on or sequential investments

• Contradiction options

  • Abandonment of Project or Division

  • Contract production

• Switching options

  • Input or output mix flexibility

Investment flexibility: real options - patents

• option to apply and use when opportunity arises

To do’s in cost benefit analysis

• Focus on relevant decision variables only

  • This might imply that you only focus on cost-saving technology

• Include labour, overhead, management cost where relevant

• Consider insourcing and outsourcing. Use data of outsourcing when within organisation estimates are not reliable

• Use cost and revenues relevant for your case (wholesale or consumer prices where you act as wholesaler or consumer)

  • e.g. IBA vs collective wastewater treatment

• Do not use consumer prices for sold products if marketing is not done by the company

• Do not use energy costs or other costs from lab or pilot plants if you want to run full scale installations

• Consider economics of scale

• Square – cube law

• Lower transaction costs (often fixed)

• Learning rate

• Do not tweak data in order to have the impression of a favourable outcome