Problems in Comparing Pension Fund Returns
Pension funds are present in some form in almost every country of the world. Hence, ideally, there should be comparisons between the returns provided by pension funds in different parts of the world. However, this does not generally happen. This is because pension funds are not like mutual funds or other investments. There are certain […]
Valuing Cash Flows in Different Periods
Cash flows vary from project to project. In some cases cash flows will occur evenly over time. There might be payments of similar amounts that will be spread out over a time period at regular intervals. On the other hand, there might be payments which are irregular and have no pattern whatsoever. The challenge in […]
Hedge Funds and Regulations
Technically, the term hedge fund does not exist. In fact, the term hedge fund applies to any fund which is sold to accredited private investors and does not have to follow through with the regulation process! Now, investment advisory is a highly regulated industry and there are several laws which have been passed to ensure […]
Why Should Central Banks Be Independent?
Last month Donald Trump fueled a debate when he called the Fed “crazy.” Political accusations started flying all across the media. However, it raised a very important point. The world realized that Donald Trump is not in control of the Federal Reserve which is the central bank of the United States. To the financially savvy, […]
China’s Predatory Lending
The Chinese government has a bad reputation when it comes to finances. Most countries including the developed ones like the United States believe that the Chinese government regularly manipulates and outsmarts them. Now imagine if the strong Chinese government went up against smaller nations like Sri Lanka, Nepal, Pakistan, and Bangladesh! There would be no […]
From the past few articles, it may seem like capital budgeting has a pre-determined procedure. All the possible scenarios that can occur have been thought of and appropriate solutions for all of them have already been developed. While this makes “capital budgeting” a good subject, it also removes the creativity from it. There is a general perception that jobs pertaining to finance and capital budgeting are boring and lack creative potential. As we shall see in this article, this is definitely not the case. The subject does provide room for ample creativity. Here are some examples:
Our NPV rule says that if a project has a positive NPV, it is financially viable. The NPV rule does not say that the project needs to be undertaken immediately. As many creative professionals have shown before, the NPV of a project can be magnified just by waiting for sometime before you execute it.
Consider the case of a building construction. You have conducted your analysis and it shows that given the cash inflows and outflows listed on your schedule, the project is a good bet. Does that mean you should execute it immediately? Well, this wouldn’t be the case if you found out additional information.
What if you found out that the government was about to declare an area near your proposed building site to be a “tax-free zone” for corporations. You would obviously expect a lot of companies to set up their shop there and this would increase the property prices, isn’t it?
Also, what if you find out that the government is about to create an underground train line linking that area to the centre of the city. Now, obviously it would make sense to wait, right? The NPV of the project is positive now. But it will be many times larger, if we waited for some more time. (Assuming that the information is credible)
So, a positive NPV does not mean that the project should be executed immediately. Any project always has two implicit options. One is to execute it right away and the other is to execute it at a later date. Many times projects with negative NPV turn around positive in a few years. The real task of the financial manager therefore is to be aware of this information that could affect their project and look into the future. What is in the present can be easily seen and discounted even by a computer!
Many times companies are faced with this decision regarding whether or not they must re-engineer the way in which they operate. This may include shutting down for a few days and then re-opening with completely different equipment, processes etc. These projects are usually viewed by financial managers as an all or nothing game. They will calculate the NPV for the entire project as a whole before they make a decision.
Now, creative financial managers on the other hand realize that it doesn’t have to be an all or nothing game. They pick and choose parts of the project and work out with combinations. They will try and find out if it is in the best interest to execute the entire project now or would executing 25% at a time for the next 4 years lead to a higher NPV.
The real point here is that the goal is to maximize the NPV. There will be given scenarios which are known to everyone. The trick is to think about the project in terms of time, partial implementation etc which are not the scenarios people would commonly think of. Like in all other professions, a good financial manager is a creative financial manager. He/she will find ways and means of maximizing the NPV.
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