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Net Present Value An NPV calculation attempts to determine the present value of a series of cashflows from a project that

stretches out into the future. This present value is a measure of how much the company is gaining at today's money by undertaking the project: in other words, how much more the company itself will be worth by accepting the project. An NPV calculation discounts future cashflows at a specified discount rate r that takes account of: 1. The time value of money (e.g. if inflation is running at 4%, 1.04 in a years time is only worth 1.00 today) 2. The interest that could have been earned over inflation by investing instead in a guaranteed investment 3. The extra return that is required over (1) and (2) to compensate for the degree of risk that is being accepted in this project. Parts (1) and (2) are combined to produce the risk free interest rate, rf. This is typically determined as the interest paid by guaranteed fixed payment investments like government bonds with a term roughly equivalent to the duration of the project. The extra interest r* over rf needed for part (3) is determined by looking at the uncertainty of the project. In risk analysis models, this uncertainty is represented by the spread of the distributions of cashflow for each period. The sum of r* and rf is called the risk-adjusted discount rate r. The net present value (NPV) is computed as the present value of the project cash flows minus the cost of the project. If NPV is negative, the present value of the cash flows from the project is less than the cost of the projecti.e., it would be cheaper to generate the cash flows by investing at the required rate than by undertaking the project. Since the cash flows could be created more cheaply by investing at the required rate, the project rate of return is below the required rate, and rejection is indicated. Alternately stated, rejecting the project and investing the cost of the project elsewhere would create larger cash flows than accepting the project. Where NPV is positive, it is cheaper to generate the cash flows by undertaking the project than by investing at the required rate of returni.e., the project rate of return is greater than the required return, and acceptance is indicated. Alternately stated, investing the project creates larger cash flows than investing elsewhere. NPV is sometimes described as the change in the value of the firm if the project is accepted. Internal Rate of Return The IRR of a project is the discount rate applied to its future cashflows such that it produces a zero NPV. In other words, it is the discount rate that exactly balances the value of all costs and revenues of the project. If the cashflows are uncertain, the IRR will also be uncertain and therefore have a distribution associated with it. A distribution of the possible IRRs is useful to determine the probability of achieving any specific discount rate and this can be compared with the probability other projects offer of achieving the target discount rate. It is not recommended that the distribution and associated statistics of possible IRRs be used for comparing projects because of the properties of IRRs discussed below. Problems in using IRR in risk analyses Unlike the NPV calculation, there is no exact formula for calculating the IRR of a cashflow series. Instead, a first guess is usually required, from which the computer will make progressively more accurate estimates until it finds a value that produces an NPV as near to zero as required. If the cumulative cashflow position of the project passes through zero more than once, there is more than one valid solution to the IRR inequality. This is not normally a problem with deterministic models because the cumulative cashflow position can easily be

monitored and the smaller of the two IRR solutions selected. However, a risk analysis model is dynamic, making it difficult to appreciate its exact behaviour. Thus, the cumulative cashflow position may pass through zero and back in some of the risk analysis iterations and not be spotted. This can produce quite inaccurate distributions of possible IRRs. In order to avoid this problem, it may be worth including a couple of lines in your model that calculate the cumulative cashflow position and the number of times it passes through zero. If this is selected as a model output, you will be able to determine whether this is a statistically significant problem and alter the first guess to compensate for it. Making the Investment Decision with NPV We discussed the concept of Net Present Value and how it could be used as a decision tool in the module addressing Present Value Mathematics or Time Value of Money. The NPV Rule says that an investor will choose to accept those investment opportunities that are expected to generate a present value of cash inflows equal to or greater than the present value of cash outflows, with present values reflecting the investors require rate of return. When faced with mutually exclusive investment choices, we should choose the one with the largest positive NPV. The NPV Rule is consistent with the overall objective of all investors: Wealth Maximization Due to competition, we would expect all investment opportunities to reflect a zero NPV on a market value basis. Of course, we all hope to find deals in which the rest of the market is mispricing the opportunity, allowing us to identify projects that offer positive NPV on an investment value basis make abnormal returns on. What about the IRR as a Decision Tool? Recall that we defined Internal Rate of Return (IRR) as the discount rate which sets the NPV of an investment opportunity equal to zero. If the calculated IRR of an investment opportunity is greater than or equal to the required rate of return, then the investor should accept the opportunity. The trouble with using IRR as a decision rule is that it does not help us distinguish between mutually exclusive projects because it ignores their scale (amount of dollars involved). Furthermore, there are some situations when IRR cannot be calculated and still other situations when there can be multiple IRRs. Thus, using the IRR as the hurdle rate for making investment decision can lead to choices that do not maximize wealth. There are many reasons for a company to accept a project with a negative NPV, some of them include: - The project is a pet project: There are many pet projects out there, in fact, even powerful governments execute pet projects with a negative Net Present Value. - The project is supporting another project: Some projects just exist to support other projects (for example, an output of this project is an input to another project). In this case, the company cares more about the output of the project rather than its NPV. - Hope: Stakeholders might be hoping that the circumstances will change with time and that the project will make more money than initially calculated. - Response to competition: Let's say that your company is a technology company producing accounting software, and a competitor releases support for its accounting software for mobile devices. Now your company needs to initiate a project that will mimic this support regardless on whether the project has a negative NPV or not. Your company must respond or else it might lose some market share. - Response to government regulations: In some countries and under certain circumstances, the government might force some companies to undertake projects with a negative NPV (usually the price of not undertaking these projects is sever business disruption). - developer no more land bank

CAPITAL BUDGET Capital expenditures are the allocation of resources to large, long term projects. The capital budget is a statement of the planned capital expenditures. It is more than a simple listing, however, and is not a "budget" in the usual sense. Given the nature of capital expenditures, the capital budget is best thought of as an expression of the goals and strategy of the firm. Creation of the capital budget is a central task that affects, and is affected by, all others areas of decision making. The "capital budgeting process" can be envisioned as shown in Figure 1. Present and anticipated business conditions are the opportunities and constraints from which the goals of the firm are developed. The goals drive the strategic decisions of capital budget and financing, but feasibility and consistency with the interdependent financing and capital budget decisions must be considered in setting the goals. Operating decisions may be thought of as the tactical choices driven by strategy, but again feasibility and consistency of operating decisions must be considered in setting strategy. The process is in actuality part simultaneous, part iterative. Given the interdependency of goals, strategy, and tactics in a changing environment, the capital budget is properly considered as an active planning document, rather than a fixed conclusion. From a narrow economic viewpoint creating the capital budget is relatively simple: a project should be accepted if the return is greater than the cost. Projects are listed in order of decreasing return, and investment should continue until the marginal return (roughly, the return to the next dollar spent) is greater than marginal cost (roughly, the required rate of return on the next dollar spent). This simple, elegant statement of the problem masks a number of complications. Projects of different risk will likely have different required returns, will be of different sizes and have different lives, and may be mutually exclusive or interdependent. The rule of accepting projects until marginal return no longer exceeds marginal cost also assumes unlimited funds. This assumption is theoretically justified by the argument that if marginal return exceeds marginal cost, increasing the capital budget will return more than it costs, and more funds should be acquired. There are, however, a number of reasons for limiting the size of the capital budget. Project analysis is often based on individual projects, but overall firm performance will be degraded if too many new projects are attempted in a short space of time. Externally, lenders or investors may be unwilling to provide funds or may require added return or limitations on an overly ambitious management. Further, some attractive projects may simply not fit the goals and strategy of the firm. Investors and creditors may react adversely to new projects if they are inconsistent with the perceived nature of the firm. Since capital budgeting is the concrete expression of the goals and strategy of the firm, capital budgeting must often consider factors that defy exact measurement or even definition. REQUIRED RATE OF RETURN The marginal cost of the project is expressed as a required rate of return (sometimes called the "hurdle rate"). Estimation of the required rate is integral to evaluating projects and setting the capital budget. The controlling concept is that of opportunity cost. Opportunity cost reflects the idea that the relevant cost of using a resource is the rate of return on forgone alternative opportunities of similar risk. For projects that are extensions of or similar to the normal operations of the firm, and so have a similar risk profile, a readily available comparable use of funds is reinvesting in the firm itself. For these projects, the opportunity cost/required rate of return/hurdle rate can be approximated by the firm's weighted average cost of capital (WACC). The WACC is the rate of return that just meets investor expectations, leaving the value of the shares of the firm unchanged. WACC is computed by first estimating the rate of return required to meet the obligations for each source of capital. These required rates are then weighted according to the target capital structure of the firm to obtain the overall rate of return required to meet the combined obligationsthe WACC. This is the return that could be obtained by reinvesting the funds within the firm (downsizing).

Where the project is outside the normal operations of the firm or has a different risk profile, the WACC is not be a good estimate of the required rate of return on the project. The required rate of return may be estimated by using the WACC for firms similar in nature to the project, or by applying capital asset pricing model at the estimated systematic risk of the project. These comparison-based estimates are satisfactory for projects of standardized technology that does not require that the firm develop new expertise. Where the project is nonstandard or innovative, or requires developing new expertise, such comparison may underestimate the risk. In such cases the required return on the new project must be arrived at by ad hoc adjustment. Decision tree, Monte Carlo, or other risk analysis tools are helpful. LIMITATIONS OF QUANTITATIVE TECHNIQUES An accept or reject indication on the above criteria does not mean that a project should be automatically accepted or rejected. Many other factors need to be considered. First, the criteria are based on estimated cash flows and an estimated required rate. The estimates are themselves subject to uncertainty and this may lead to an increase or safety factor in the "hurdle." Second, as noted, the estimates proceed on an individual project basis, and there may be an interaction between projects. Third, and perhaps most important, the criteria consider only cash flows, and some factors cannot be reduced to a monetary basis. It must be remembered that a capital budget is in reality the strategy chosen to reach the goals of the firm. The indications of the quantitative economic analysis are only a part of the strategic planning process and are subsidiary to overall strategic considerations. Unless a project is compatible with the goals of the firm, it will not be accepted. Conversely, if a project has nonmonetary benefits or interaction with other projects, it may be accepted despite a negative indication. Again, the capital budget is a planning document. The greatest contribution of the application of the capital budgeting techniques is not the indicated decision, but the heuristic benefits of greater understanding. Finally, ethical standards are a vital part of the strategic considerations. An otherwise acceptable project may be unacceptable on ethical grounds. The social impact of projects has become increasingly important. It is necessary to consider the externalities the effects of the project that are not felt by the firm. Externalities include such items as environmental impact and required increase in infrastructure. (http://www.referenceforbusiness.com/encyclopedia/Bre-Cap/Capital-Budget.html#b) What major steps are involved in the capital budgeting process? Conceptually, the capital budgeting process involves six logical steps. 1) First, the cost of the project must be determined. This is similar to finding the price that must be paid for a stock or bond. 2) Next, management must estimate the expected cash flows from the project, including the value of the asset at a specified terminal date. This is similar to estimating the future dividend or interest payment stream on a stock or bond. 3) Third, the riskiness of projected cash flows must be estimated. To do this, management needs information about the probability distributions of the cash flows. 4) Fourth, given the riskiness of projected cash flows and the cost of funds under prevailing economic conditions as reflected by the riskless rate, RF, the firm must determine the appropriate discount rate, or cost of capital, at which the project=s cash flows are to be discounted. This is equivalent to finding the required rate of return on a stock or a bond investment. 5) Fifth, expected cash flows are converted to a present value basis to obtain a clear estimate of the investment project=s value to the firm. This is equivalent to finding the present value of expected future dividends or interest plus principal payment. 6) Finally, the present value of the expected cash inflows is compared with the required outlay, or cost, of the project. If the present value of cash flows derived from a project exceed the cost of the investment, the project should be accepted. Otherwise, the project should be rejected.

A Capital Budgeting decision rule should satisfy the following criteria: Must consider all of the project's cash flows. Must consider the Time Value of Money Must always lead to the correct decision when choosing among Mutually Exclusive Projects.

4 Quadrant Model Investors have different reasons for investing in the property market. For example some want to invest in properties that they can redevelop, or actively manage, others prefer a property that is already let that requires little management. Hence, particular property characteristics need to satisfy the investor's requirements. Primarily the relationship between office space and investment must be established. The property market is a set of three closely interdependent markets: 1. The occupier market, which is the demand and supply of space for occupation by firms and households governed by rental price. 2. The investment market or otherwise asset market through which the ownership and management of the stock is financed by landlords, and governed by asset valuations and investment returns. 3. The development market, through which changes in the volume of stock available to both occupiers and landlords are brought about by new construction. It is governed by the relationship between asset values and construction costs. In The occupier market the axes depict the determination of rent and the stock of space available in the market for occupation, and are linked by simple demand. "... At the existing supply of space in the market (O), the point at which that line intersects the demand function will tell us the current equilibrium rent (R), given that amount of space in the market..." The higher the rent, the lower the demand for space and the more space available, the lower the rent. The demand curve is dependent on economic growth and prevailing technological and technical changes. For example, an economic growth will result in an increase in total demand, and hence shifting the demand curve up and out. The northwest quadrant represents the investment market, were the curve of the line is the investment yield or capitalisation rate. It is the ratio between rents, which are determined in the occupier market, and the value which landlords are willing to hold building. A building with say a rent at 100/m and yield of 10%, the capital value will be 1,000. With a given investment yield, the higher the rent, the higher the value of the building. The investment yield, which produces the rate of return, will be set dependant on the following: Covenants Trading costs Current rate of return on risk-free assets Any premium to take account for risk involved in holding property compared to government bonds Rental growth expectations over holding period => Therefore the required yield by investors to hold property can be expressed as: Yield= Risk Free rate + Property Premium - Expected Rental Growth The two bottom quadrants "depict the long-run effect of the real estate development industry, by showing the impact of construction on the total stock of built space in the market" (Geltner D. & Miller N.G. (2001:29)). The more buildings will be supplied when the capital value of buildings (determined by rent and yield) increases. However, increased construction increases development costs through increased competition for land, materials and labour. The more construction there is, the larger will be the change in the stock of space. The line in the southeast quadrant indicates the volume of new development-required in-order to maintain stock space at current levels. This is calculated by the ratio of existing stock over useful life of building. Placing all the quadrants together we get an insight on how the commercial property

market (and generally the property market) works. For example, referring to the diagram, the current stock space is O. With stock O and given the demand curve for space from occupiers current rents are R per m. At the prevailing investment yield Y, owners are willing to hold buildings at rents R per m at a capital value C per m. Subsequently, developers will build N m of new space at C per m and if N is the exact quantity of space required to maintain stock at its current size volume of stock will not change. The quadrant graph can be used to map out the processes of change through the three markets. The red dotted lines in the quadrant graph show the effects increased demand has on the other markets. Following the red dotted line anticlockwise, it is seen that increased demand, increases rents to R' and at prevailing yields increases capital value of buildings to C'. Increased tenant demand for space, increases rent and in turn increase returns for investors. Therefore it seems that investors are influenced by tenant demand, as the former seek high returns (capital values). The quadrant graph illustrates smooth adjustments to change in the property market were in reality everything changes at once. For example, an increase in demand will increase rents, but it may also lead to a fall in yields as investors' future rent growth expectations increase. The property market characterised by fluctuating demand, lumpy investments and long production times means that demand and supply are in fact in disequilibrium every year, "... with successive rises or falls in price as producers search for the 'right' level. This phenomenon goes by the name cobweb theory.

How to mitigate risk from shopping centres? Performance risk: risk that the retail sector does not outperform the office, residential, industrial and/or other sectors. Corio has chosen retail because we believe that this is the sector in which we can add most value through our active local+ management approach. The advantage is that we can specialise and develop expertise in shopping centres, without having to allocate resources to other areas of expertise. Another advantage is the multitenant character of the retail sector, which reduces vacancy risk as compared to other sectors, like offices and industrials. Competitive risk: there is risk that consumers will increasingly use other shopping channels, like e- & m-commerce. We have in-house research teams to monitor and predict developments and assess their impact on our business. In addition we actively manage our centres to attract consumers. We also engage other parties (from production companies, wholesale retailers, consumers, tenants to investors) in discussions about developments in the retail sector, innovative products or retail concepts, consumer behaviour, etc. Economic risk: there is a risk that consumer confidence will decline, leading to reduced consumer spending that in a turn could lead to a fall out of tenants. Through our onsite centre managers we are in close contact with consumers and our tenants and this allows us to act quickly in response to changing demand and supply. Tenant mix/leasing risk: Our in-house decentralised leasing management optimises the mix of tenants and picks those tenants with the most appealing product range. While we can respond flexibly to market trends and catchment area needs, the timing of any changes in the tenant mix might be influenced by local leasing regulations. Refurbishment risk: Our active in-house centre & technical managers keep our shopping centres up to date, taking our stakeholders, like tenants, co-owners and municipalities into account.

How real Estate developers manage their risks? 1. Introduction Due to the current economic crisis caused by the sub-prime mortgages and the recent default of Dubai World, real estate has become a popular subject for debate. In this article I will describe the real estate development risks and their mitigation. Real estate development consists of land assembly, development, financing, building and the lease or sale of residential, commercial and industrial property. Real estate development is a very dynamic process with a significant average duration. Real Estate Types First of all what types of real estate are there? Real estate consists of the following types. a) Retail: These are projects suitable for shopping purposes with modern outfitting, appropriate access and visibility and sufficient parking space. The occupiers will be tenants. Investors and, more exceptionally occupiers, will be purchasers. b) Residential: This concerns the development of buildings suitable for family living on a long-term basis. The ultimate occupier will be a resident; however the ultimate investor can vary from owner-occupier to institutional investor. c) Offices: Buildings that could be used for market standard office buildings. The buildings should normally be fitted for occupancy by multiple tenants. d) Industrial/logistics: Industrial real estate building for multi or single-tenant purpose. The investors are the ultimate purchasers. e) Mixed-use: This concerns projects being a combination of two or more of the above types. f) Area development: This concerns complex long-term mixed-use developments, which are often undertaken in joint effort with public bodies. 2 Risks and risk-mitigating measures at the project level Each type of Real Estate has its own risks. Below is a description of the risks that may occur in the Real Estate business, along with the mitigating measures. Project Risks The risks can be grouped in the following clusters: a) Land value risk: land acquisition costs and the risk that the value of acquired land changes due to market circumstances. b) Land exploitation risk: the risks mainly related to environmental issues. c) Planning permit risk: the risk that no usable planning permit is received or that this process takes longer than expected. This risk also applies to other municipal approvals/permits, such as commercial licenses. Whether or not grants are obtained is also included in this risk. d) Construction risk: this regards pricing, design, quality and possible delays. e) Revenue risk: there are many factors that influence revenues. These include yields, rent levels, sales price levels, inflation and interest rate levels, demand and supply f) Duration risk: the duration is a consequence of other risks. It can impact interest costs, but can also cause other problems, such as claims from tenants if the agreed opening date of a shopping centre is not met. A delay could also mean that the project has to face adverse market circumstances. g) Political risk: the risk that the project encounters problems due to a change in government, regulations, etc. h) Partner risk: the risk that a partner in the project cannot meet its obligations or disagrees on the way forward. i) Legal risk: this covers a broad area of topics: possible objections against changes in zoning, liability risks or contracts which have not been drawn up correctly. It also concerns the risk of not obtaining the required permits and the risks involved with buying existing companies to acquire land positions. Tax risk is also included in the legal risk.

Risk mitigating measures at project level To mitigate the above mentioned risks the following mitigations can be highlighted: a) Research is essential in assessing virtually all kinds of risks. Important research areas will include: 1) Forecast of yield development; 2) Allocation strategy; 3) Investor demand; 4) Occupiers and consumer demand: The research into partners (financial position and due diligence check) is also included under research and should be satisfactory; b) Phasing: By adequately phasing projects, the steps to be taken are smaller, with possible exits following each phase. c) Contracts: Many risks can be mitigated by carefully drawn up contracts. It is therefore essential that the legal department is involved, either directly or indirectly by instructing local lawyers. Regarding construction risk it is crucial to use controlled pricing mechanisms when entering into construction contracts. Therefore, it is preferred to have a fixed price contract to the largest possible extent. Depending on the project, flexibility might be needed to achieve the best price possible or to allow for tenant demands, design changes etc. All projects need also to be insured in line with insurance policies. Furthermore, the quality of partner agreements (clauses on the decision process and exit possibilities) need to be highlighted. d) Cost calculations: A development appraisal consists of assumptions which become more certain in the course of the project. The risk of surprises and wrong assumptions made during the process need to be mitigated by meticulous calculations. These will be made during the development process as the design will evolve toward final specifications and will have to take into account inflation levels, price increases as a result of increasing demand etc. Where necessary, these should be verified externally. e) Pre-lease/-sales: In order to test the market of end-users before entering into the commitment to actual starting of construction of a project, a certain rate of pre-letting or pre-selling is required. Its also the ambition to enter other major commitments (a.o land purchase) conditional upon these market-tests. In addition to demonstrating the market appetite this will reduce the amount at risk as well, since pre-leasing/selling locks in part of the revenues. f) Timing payments: in the case of costs it is preferred to pay as late as possible, whereas in the case of revenues it is preferred to receive these as early as possible. Next to the obvious advantage of lower interest costs, this strategy provides control in case of possible disputes, relating to for example contracts. Furthermore, it is preferable to keep the level of spending in the development phase to such a level that a real go/no-go decision before the start of the construction phase is still possible. 3 Risk-mitigating measures at the portfolio level At the portfolio level there are a number of risk mitigating measures in place. These are the following: Portfolio diversification A Real Estate developer is often active in more than one country; the markets in these countries differ. Because the portfolio of the company is spread over several countries, segments and project sizes the portfolio is rather diversified. However, it is difficult to set up exact target portfolio diversification, since it is not possible to determine which diversification would create an optimal risk/return ratio. In order to be able to manage the portfolio and diversification over countries and segments, regular reports are essential together with an outlook based on the existing pipeline. Maximum Investment at Risk at the portfolio level Current commitments minus secured revenues should never exceed pre-specified limits on amounts at the portfolio level.

Restrictions regarding strategic land positions Strategic land positions concern land /buildings without sufficient rental income and not yet zoned for new development functions. At the portfolio level the following limits should be in place: - the total investment in strategic land positions should not exceed a pre-specified limit on amounts. - strategic land will only be purchased for the purpose of residential or retail development. - the maximum tenure of strategic land positions is restricted in line with the pre-specified policy: for example, differentiation between mature and growth countries. To diversify the risk the average tenure of holding the land for strategic purposes should be roughly spread over a pre-defined number of years which should be monitored via periodic reporting.

How to Mitigate Financial Risk


Cash flow is the lifeblood of most successful business operations. The more access a company has to cash flow, the more likely it is that management can pursue profitable opportunities when they come along. This type of risk is referred to as financial risk, and investors usually want to invest in companies with low financial risk. 1) Sell inventory and current ssets. The easiest way to raise funds is to sell Current assets. Current Assets are listed first on the balance sheet as they can all be liquidated in one year or less. Discuss the sale with bankers and brokers that specialize in the asset. 2)Request a sale leaseback from your banker This only works if you own the building in which you operate. In most cases, your bank will purchase the building from you and then lease it back to you. This provides a large cash inflow from the sale of the building which can then be used to pay off debtors.
3) Issue stock. While equity is considered costlier than debt, a company is not required to pay stockholders back. There are also fewer restrictions connected to stock issuance compared to a bank loan. Contact your banker to request information about issuing stock. In general, stock issuance costs 7 percent of the total amount raised. 4) Request longer terms from suppliers; that is, see if your suppliers will be okay with financing your purchases over a longer period of time. While this is essentially a loan, it is not considered debt. The result will be an increase to accounts payable.

5) Shorten payment terms with customers; that is, reduce the amount of time customers are able to maintain service or own a product on credit. The result will be a decrease in accounts receivable.
6) Pay off debts with additional cash raised. The more you can pay off your debts the lower your financial risk will be. Contact bankers to pay off bank loans first followed by bondholders.