Blog 8: Investment appraisal tools

This week we will discuss the nature of risk in an international business context. Firstly, we should identify what is risk. According to Bessis (2010), “Risk is not identical to uncertainty. Uncertainty refers to the randomness of outcomes. Risk refers to the adverse effect on wealth that such outcomes have. Risk exists only when uncertainty can have a potential adverse effect, which is a possibility of loss.”(p. 26)

To reduce investment risk, there are risk assessment and advanced investment appraisal tools to assess the risk to let manager know the investment is worth or not.

Before making an investment, managers have to estimate the investment project. Investment analysis tools may help manager to evaluate the risk that associate with the project. There are several investment analysis tools for manager to estimate, such as payback period, accounting rate of return. However, these tools ignore the timing of cash flows. Therefore, managers have to take the time value of money into account to measure the risk and inflation that achieve the most effective assessment of the investment project. They may use net present value (NPV) or internal rate of return (IRR) methods to calculate the discount of cash flow. However, compare NPV with IRR. The time value of money measured by NPV that may absolute calculate the amounts of wealth change while IRR cannot. For example, there are two projects, Project A is 5 years project and Project B is 7 years project. NPV can give manager the figures for both projects. However, IRR cannot give the figures for both project which make manager cannot compare the project whether is worth to do or not easily. Therefore, even both of them are time-adjusted measures of profitability, most of academics prefer NPV technique than IRR. In fact, large organizations would use three or four methods for project appraisal. It is because they don’t rely on only one project appraisal for evaluation.  (Arnold, 2008)

However, it is a bit difficult when using the NPV method, which comes up with estimate cash flows and cost of capital. It is difficult to determine cash flows and cost of capital. The input of information is important for decision because good decisions are born with good information. Therefore, mathematical technique is only one of the elements for investment decision. There are other factors that affect the decision such as strategy, social context which have mentioned in previous blog post.

How the corporate apply this theory in the real world? Dolce & Gabbana (D&G) plans for 15 new stores across China in an effort to boost business in the world’s fastest-growing luxury-goods market. (The wall street journal, 2011) It is an enormous project for D&G, why D&G would launch this strategy?

I think there are several factors that push D&G forward to launch this strategy. Firstly, Research group CLSA Asia-Pacific Markets estimate that the sale of luxury goods will reach $101 billion in 2020. Secondly, Sales in China and other parts of Asia account for 16% of D&G global sales (nearly $1.46 billion) last year. The sales jumped up 26% from a year earlier. Lastly, China would influence the future of design and the fashion industry.

However, there are some problems for these factors. Is the figure from CLSA research group calculated by investment appraisal? It is huge difference if $101billion is cash flow value rather than net present value. Also, how can D&G sure that the estimate profit from China can cover the development cost of this enormous project? Just based on the previous sales figure? 

In my opinion, even there are many other factors that affect D&G’s decision, such as China would influence the future of design and fashion industry and D&G have to follow the competitor (Which I have mentioned in previous blog post- Pros and Cons of Foreign Direct Investment), but investment appraisal tools are also important. Therefore, it is better for D&G consider the project with the investment appraisal tools that may make the best decision to bring benefit for the shareholder. 

Reference:

Arnold, G. (2008) Corporate Financial Management. 4^th edn. Harlow: Financial Times Prentice Hall

Bessis, J. (2010) Risk Management in Banking. 3^rd edn. Chichester : Wiley & Sons Ltd