Assessing Manufacturing Capital Investments in the Global Market

Transcription

1 Paper ID #7476 Assessing Manufacuring Capial Invesmens in he Global Marke Dr. Rex C Kanu, Ball Sae Universiy Dr. Rex Kanu is he coordinaor of he manufacuring engineering echnology program in he Deparmen of Technology a Ball Sae Universiy in Muncie, Indiana, where he eaches courses in plasics maerials and processing. c American Sociey for Engineering Educaion, 2013 Page

2 Assessing Manufacuring Capial Invesmens in a Global Marke Absrac Manufacuring aciviies are becoming more global because of he need for manufacurers o be closer eiher o he sources of raw maerials or he markes of he manufacured producs or boh. Ofenimes, he sources of boh raw maerials and producs markes are locaed in foreign counries. Thus, as a consequence of he rapid expansion of global economic aciviies some universiies in he Unied Saes are now requiring heir incoming freshmen o ake a course in foreign language before graduaion. Therefore, i is appropriae o inroduce sudens in a manufacuring engineering echnology program o he ools ha hey may need o evaluae manufacuring projecs in he global manufacuring marke. These projecs may have inheren risks or uncerainies emanaing from poliical insabiliies in he counries where he projecs are locaed, or from unproven echnologies (such as deep-sea drilling of crude oil), or from he shorage of skilled labor. Tradiionally, capial projecs wih uncerainies have been evaluaed using ools such as he ne presen value (NPV) capial asse pricing model coupled wih sensiiviy, break-even, or cash-flow scenario analyses. These ools mainly examine he variabiliy in projeced cash flows of projecs wih uncerainies. Alernaively, wih adjused ne presen value (ANPV) capial asse pricing model, each cash flow sream in a projec is assigned an expeced rae-of-reurn ha is commensurae wih he risks of he cash flow. This allows for he decoupling of individual cash flow sream (e.g., capial oulays, revenue, axes) and heir subsequen proper evaluaion raher han use a single rae-of-reurn as is done in he radiional ne presen value (NPV) model. In his sudy, ANPV was used o evaluae he economic viabiliy of a plasics plan in a foreign counry and he resuls compared wih hose of he ne presen value (NPV) model. The primary inen of his sudy was o inroduce manufacuring engineering echnology sudens o capial invesmen analyses of manufacuring venures in he inernaional arena. To assess if his goal was achieved, a survey was given a he beginning and a he end of he course o assess sudens learning oucomes. The resul of his sudy will be presened a he conference. Inroducion In recen imes one is cognizan of increased global aciviies in he manufacuring secor of he U.S. economy as some companies moved pars or all of heir operaions off-shore for various economic reasons. Similarly, he U.S. has also seen wihin is borders he increased presence of foreign companies such as Toyoa, Honda, and Hyundai. An example of a produc ha illusraes he globalizaion of manufacuring aciviies is he Chrysler s PT Cruiser, which was designed in Germany, manufacured in Mexico, and sold in he US. Given his scenario, i seemed appropriae in a manufacuring engineering echnology program a a Midwesern Sae Universiy o inroduce o is sudens, a ool for analyzing capial invesmens in a global manufacuring arena. Page

3 In his sudy sudens were assigned a projec o creae a plasics company ha would manufacure disposable plasics knives, forks, and spoons o be sold o reailers like Wal-Mar. Using he coss of esablishing he company (invesmen coss), coss of manufacured goods, axes, and depreciaion of fixed asses, hey deermined he NPV of he projec. The decision rule for NPV is o accep any projec wih a posiive NPV and o rejec projecs wih negaive NPVs. One is indifferen o projecs wih NPV=0. ANPV was subsequenly used o evaluae he same projec o see if a differen financial decision could be reached wih respec o he financial viabiliy of he projec. Theory According o modern finance heory, four seps are usually encounered in evaluaing a capial invesmen opporuniy. These are (1) Forecas a projec s expeced incremenal afer-ax cash flows; (2) Assess he projec s risk; (3) Esimae he opporuniy cos of capial, ha is, he ineres rae of equivalen-risk invesmens raded in he capial marke; (4) Calculae he Ne Presen Value (NPV) using he discouned cash-flow formula. NPV has been described as he presen value of fuure cash flows minus he purchase price (invesmen coss). 1 NPV is a cenral ool in discouned cash flow analysis and is a sandard mehod for using he ime value of money o appraise long-erm projecs. 1 Mahemaically, NPV can be expressed as follows: E 1 I R X NPV 0 (1) 1 E where NPV 0 = ne presen value of a projec E(X ) = expeced cash flow in period E(R) = expeced rae of reurn required by invesors E(I ) = expeced invesmen expendiure in period E(X I ) = expeced ne cash flow in period One of he major difficulies in using equaion (1) resides esimaing he required rae of reurn, E(R). The soluion o his problem is provided by he Capial Asse Pricing Model (CAPM), which describes he relaionship beween risk and expeced reurn in an efficien marke. Developed in he 1960s by Jack Treynor, William Sharpe, and John Linner 2, CAPM capures in a single saemen, he concep ha invesors expec o be rewarded for underaking risky projecs over riskless projecs. In oher words, invesors are only willing o underake risky projecs if hey are compensaed wih risk premia. CAPM is expressed as Page

4 ~ E( R ) R i F ~ Ri ~ Cov, R i ~ Var R M i M ~ E R M R F (2) where β i = he relaive volailiy coefficien of he projec i wih respec o he marke porfolio of projecs. R F = he risk-free rae of reurn for he period from -1 o. E(R i ) = expeced reurn on projec i for he period from -1 o. E(R M ) = expeced reurn on he marke porfolio M; Tildes (~) are used o denoe random variables Equaion (1) is based on he assumpion ha he Value Addiiviy Principle (VAP) holds. VAP saes ha he sum of he pars is always equal o he whole. VAP allows us o adjus differen cash flows under independen risk assumpions, and sum he resuls o obain he oal value of he projec. Using VAP, Lessard 3 developed he Adjused Ne Presen Value (ANPV) model for evaluaing foreign and domesic projecs. Lessard s ANPV model builds on he work of Myers 4, who developed he Adjused Presen Value approach for evaluaing projecs in a world of imperfec capial markes where he ineracions beween financings and invesmen decisions mus be considered o reasonably esimae he value of projecs. ANPV can be expressed as ANPV Capial Oulay Operaing Taxes T Expenses 1 5 T Taxes 1 E( R ) T 1 E( R ) 1 E( R ) 0 1 OP I Depreciaion Tax Shields 1 E( R ) 1 E( R ) 1 3 Gross Revenue T 1 2 R T DEP 1 4) (3) The negaive signs represen cash ouflow while he posiive signs represen cash inflow. The expeced raes of reurn, E(R 1 ) o E(R 5 ), can be differen from each oher depending on he risk premium associaed wih each cash flow. Class Projec Sudens creaed a ficiious plasics manufacuring company ha manufacured disposable plasics knives, forks, and spoons, which were packaged in a box conaining 16 of each iem. These producs were sold o reailers such as Wal-Mar and Targe. To make hese producs, he company had o inves in land, building, plasics injecion molding machines, auxiliary plasics processing equipmen, injecion molds, and plasics raw maerials (resins). Provisions were made for he personnel required o successfully run he manufacuring operaion. All he coss esablishing and operaing he company are shown in appendix A. The corporae ax rae used in his sudy was 35%. Page

5 Esimaing he expeced rae of reurn required by invesors, E(R) In esimaing he expeced rae of reurn, he assumpion was made ha he company could be locaed in eiher he US or a Lain American counry such as Peru. For he US opion, he risk free rae of reurn, R F was 6%, he marke rae of reurn, R M, was 10% (S&P 500), 5 he unlevered bea, β, for he company was This is bea value for he diversified chemical indusry, which is a close subsiue for he plasics company s bea value. Subsiuing hese values in equaion (2) yields an expeced rae of reurn of 11.2% for he plasics company. E 6% % 6% 11.2% R US Esimaing he E(R) for Peru wih equaion (2) seemed a bi more difficul because of sparse financial daa o deermine he Peruvian marke rae of reurn, R M(Peru). However, based on Peru s bond raing, i was deermined he Peru counry risk premium relaive o he US was 4%. 7 Therefore, he rae of reurn for he Peruvian opion was esimaed o be 15.2% (11.2% + 4%). Discussion of Resuls Ne Presen Value (NPV) In using equaion (1) o esimae he ne presen value (NPV) of he plasics company based on is expeced ne cash flow, i was arbirarily assumed ha he life of he company was 15 years given ha mos chemical companies have an average gesaion period of 20 years. For he US opion he NPV was $4.6 million (see appendix A) while for he Peru opion i was $2.5 million (appendix B). According o he decision rule of NPV, he plasics company would be profiable in boh counries. However, i is worh higher if i is locaed in he US because of he counry risk associaed wih locaing he company in Peru. Neverheless, i should be noed ha here are many facors such as foreign exchange risk and labor wages ha play imporan roles in evaluaing he financial viabiliy of a company. This sudy has considered only he counry risk facor o illusrae he conceps of risk and risk premium associaed wih capial invesmen. Adjused Ne Presen Value (ANPV) Wih ANPV, a projec could be evaluaed by examining he risk associaed wih each cash flow sream. For insance, if he invesors were from he US and he plan was locaed in he US or Peru, bu all he producs made by he company were sold in Peru. Then he revenue cash flow would be subjeced o he counry risk, herefore, he revenue cash flow would be discouned using 15.2% rae of reurn while all he oher cash flow sreams would be discouned a 11.2%. Wih his scenario, he ANPV would be -$7.7 million (appendix C). The NPV decision rule would sugges ha he projec no be underaken because is ne presen worh was negaive. On he oher hand, if he financing sources were Peruvian and he producs manufacured in Peru bu sold in he US marke, hen all he cash flow sreams would discouned a 15.2% while in revenue cash flow would be discouned a 11.2% because he revenue was realized in US. Given his scenario, he ANPV would be $14.8 million (appendix D) and NPV decision rule would sugges underaking he projec because of is posiive value. I should be noed ha in boh scenarios, ransporaion coss were no considered since i would have he same effec on he Page

6 projec assuming he producs were sold on F.O.B. (freigh-on-board) basis. Tha is, he manufacurer of he producs had he responsibiliy of shipping he producs o a receiving por. Assessing Sudens Learning Oucomes Before he projec was inroduced o he sudens, he sudens were asked o describe in heir own words heir undersanding of (1) ime value of money, (2) ineres rae, and (3) wha ineres raes measure? Following he compleion of he projec, sudens were again asked o describe heir undersanding of he same conceps. Table I shows he resuls of he survey, which indicaes ha sudens had a highly improved undersanding of he conceps of money han hey did of he conceps of risk and risk premium even hough heir undersanding of he laer improved by 33%. Table I. Survey of Invesmen Conceps Concep Before Afer Difference Time Value of Money 8% 100% + 92% Ineres Rae 0% 33% + 33% Wha Ineres Raes Measure? 0% 33% + 33% Conclusion This sudy describes he use of a projec o inroduce sudens in a manufacuring engineering echnology program he conceps of evaluaing capial invesmens in he inernaional manufacuring arena. These conceps include he ime value of money, risk, and risk premium, which are embedded in he ne presen value (NPV) and adjused ne presen value (ANPV) formulae for evaluaing capial projecs in domesic and foreign counries. This sudy showed ha sudens undersanding of hese conceps improved afer compleing he projec. Also, his sudy showed how o successfully inegrae echnical and financial ools in an engineering echnology program. Acknowledgmen I would like o acknowledge he sudens who paricipaed in he class projec. They were Joshua Coleman, Bre Crawford, William Gregory, Sarah Horn, Lance Jones, Adam Keever, Jiyang Liu, Brian McNeil, Cameron Riewe, Jason Rosenbeck, Benjamin Speedy, and Tye Shelon. Bibliography 1. hp://en.wikipedia.org/wiki/ne_presen_value, Page

7 2. Sharpe, W.F., Capial Asse Prices: A Theory of Marke Equilibrium under Condiions of Risk, Journal of Finance, 19, 1964, Lessard, Donald R., Evaluaing Foreign Projecs: An Adjused Presen Value Approach, in Inernaional Financial Managemen, edied by Donald R. Lessard, Warren, Gorham, and Lamon, Boson, 1979, Myers, Sewar C., Ineracions of Corporae Financing and Invesmen Decisions, Journal of Finance, 29 (1), 1974, Socks, Bonds, Bills and Inflaion Yearbook, hp:// Beas by Secor, hp://pages.sern.nyu.edu/~adamodar/new_home_page/daafile/be..., Bond s raing, hp:// Page

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