Alternative investment analysis

AN EXAMPLE TO ILLUSTRATE PRINCIPLES OF ALTERNATIVE investment analysis. In making a choice among various alternative investments, it is necessary to recognize the need to compare one investment to... 

Because of the different methods used for treating interest as a cost, a definite statement should be made concerning the particular method employed in any given economic analysis. Interest costs become especially important when making comparisons among alternative investments. These comparisons, as well as the overall cost picture, are simplified if the role of interest in the economic analysis is clearly defined. 

Methods for including the cost of capital in economic analyses have been discussed in Chap. 7. Although the management and stockholders of each company must establish the company s characteristic cost of capital, the simplest approach is to assume that investment of capital is made at a hypothetical cost or rate of return equivalent to the total profit or rate of return over the full expected life of the particular project. This method has the advantage of putting the profitability analysis of all alternative investments on an equal basis, thereby permitting a clear comparison of risk factors. This method is particularly useful for preliminary estimates, but it may need to be refined further to take care of income-tax effects for final evaluation. 

Example 5 Comparison of alternative investments by different profitability methods. A company has three alternative investments which are being considered. Because all three investments are for the same type of unit and yield the same service, only one of the investments can be accepted. The risk factors are the same for all three cases. Company policies, based on the current economic situation, dictate that a minimum annual return on the original investment of 15 percent after taxes must be predicted for any unnecessary investment with interest on investment not included as a cost. (This may be assumed to mean that other equally sound investments yielding a 15 percent return after taxes are available.) Company policies also dictate that, where applicable, straight-line depreciation is used and, for time-value of money interpretations, end-of-year cost and profit analysis is used. Land value and prestartup costs can be ignored. 

When the reason for a replacement falls in the first general type, the only alternatives are to make the necessary changes or else go out of business. Under these conditions, the final economic analysis is usually reduced to a comparison of alternative investments. 

Analyze and review impact for alternatives— What are the impacts on time to market, investment cost, and product cost for each alternative Financial analysis is a key element of this step because senior management uses financials as a critical business indicator. Therefore, each alternative needs to be evaluated versus a financial model. What are the risks and tradeoffs to consider for each alternative ... 

Schneeweis, X, and Spurgin, R. (1998), Multi-Factor Analysis of Hedge Funds, Managed Futures, and Mutual Funds, Journal of Alternative Investments, Vol. 3, No. 4, Winter, pp. 1-24. 

The economic analysis of investment alternatives generally entails the estimation of cash flows and the application of some measure of worth, such as net present value or the internal rate of return, in order to make a decision. The estimation of these cash flows requires the estimation of prices, whether they be the price of goods sold to forecast revenues or the estimation of wages to forecast labor costs. Over time these prices change. An increase in price is known as inflation, while a decrease in price is termed deflation. These concepts and their measurement are explained in this chapter. Cash flow analysis methods are revisited under the assumption of price changes, as their effects can be significant (Fleischer 1994). This is especially true when one considers after-tax cash flow analysis, as the effects of depreciation and taxes represent one of the most important aspects of investment analysis (Park and Sharp-Bette 1990). 

Aspen IPE usually begins with the results of a simulation from one of the major process simulators (e g., ASPEN PLUS, HYSYS, CHEMCAD, and PRO/II), it being noted that users can, alternatively, provide equipment specifications and request investment analysis without using the process simulators. In these notes, only results from ASPEN PLUS are used to initiate Aspen IPE evaluations and only capital cost estimation is emphasized. Readers should refer to the Aspen IPE User s Guide (press the Help button in Aspen IPE) for detailed instructions, explanations, and for improvements in new versions of the software system. 

With the cost/benefit model fully defined, one next must forecast levels of attributes or, in other words, benefits and costs. Thus, for each alternative investment, one must forecast the stream of benefits and costs that will result if this investment is made. Quite often, these forecasts involve probability density functions rather than point forecasts. Utility theory models can easily incorporate the impact of such uncertainties on stakeholders risk aversions. On the other hand, information on probability density functions may not be available, or may be prohibitively expensive. In these situations, beliefs of stakeholders and subject matter experts can be employed, perhaps coupled with sensitivity analysis (see Step 7) to determine where additional data collection may be warranted. 

The final step involves calculating the expected utility of each alternative investment. This step also involves using sensitivity analysis to assess, for example, the extent to which the rank ordering of alternatives, by overall utility, changes as parameters and attribute levels of the model are varied. 

In order to make a valid decision regarding alternative investments (projects), it is necessary to know a baseline rate of return that must be attained in order for an investment to be attractive. A conpany that is considering whether to invest in a new project always has the option to reject all alternatives offered and invest the cash (or resources) elsewhere. The baseline or benchmark investment rate is related to these alternative investment opportunities, such as investing in the stock market. Incremental economic analysis is illustrated in Examples 10.4 and 10.5. 

The annualized capital cost (ACC) is the product of the CRF and TCC and represents the total instaUed equipment cost distributed over the lifetime of the project. The ACC reflects the cost associated with the initial capital outlay over the depreciable life of the system. Although investment and operating costs can be accounted for in other ways such as present-worth analysis, the capital recovery method is preferred because of its simplicity and versatUity. This is especiaUy true when comparing somewhat similar systems having different depreciable lives. In such decisions, there are usuaUy other considerations besides economic, but if all other factors are equal, the alternative with the lowest total annualized cost should be the most viable. 

Kasner, E., Breakeven Analysis Evaluates Investment Alternatives, Chemical Engineering, Feb. 26, 1979, pp. 117-118. 

The TVM takes into consideration the total time that the principal was tied up into the investment. For the shares that we purchased on 1/1/01, the 100 was tied up for one full year. This portion of the investment made 10% in one year. But the shares that were purchased on 12/1/01 tied up 100 for only one month, which is a significantly higher return than the 10% per year. In fact, if an investment gained 10% every month like the latter share purchase, it would gain 207.5% in one year TVM formulas give the most accurate ROI calculation possible. They are the same formulas used by large investors and lending institutions to evaluate capital expenditures and investment alternatives. Unfortunately, in a real-world example, you would normally be unable to calculate the true TVM-ROI because the calculations require the application of advanced numerical analysis. 

Capital investment decisions are best made within the context of a life-cycle cost analysis. Life-cycle cost analysis focuses on the costs incurred over the life of the investment, assuming only candidate investments are considered that meet minimally acceptable performance standards in terms of the non-inonetary impacts of the investment. Using life-cycle analysis, the capital investment decision takes into account not just the initial acquisition or purchase cost, but maintenance, energy use, the expected life of the investment, and the opportunity cost of capital. When revenue considerations are prominent, an alternative method of analysis such as net benefit or net present value may be preferred. 

The economic problem is to identify the best capital investment from a set of possible alternatives. Selection is made on the basis of a systematic analysis of expected costs, and revenues if they differ, over time for each project alternative. 

Capital investments can also be selected on the basis of other measures of performance such as return on investment, internal rate of return, and benefit-cost ratio (or savings-to-investment ratio). Flowever, care must be taken in the application of these methods, as an incremental analysis is required to ensure consistent comparison of mutually exclusive alternatives. Also, rather than requiring a separate value to be calculated for each alternative, as in the case of the life-cycle cost method, these other methods incorporate the difference between two mutually exclusive alternatives within a single measure. For example, the net benefits measure directly pressures the degree to which one alternative is more economically desirable than another. 

In a cost-benefit analysis, both costs and consequences are valued in dollars and the ratio of cost to benefit (or more commonly benefit to cost) is computed. Cost-benefit analysis has been used for many years to assess the value of investing in a number of different opportunities, including investments (or expenditure) for health care services. Cost-effectiveness analysis attempts to overcome (or avoid) the difficulties in cost-benefit analysis of valuing health outcomes in dollars by using nonmonetary outcomes such as life-years saved or percentage change in biomarkers like serum cholesterol levels. Cost-minimization analysis is a special case of cost-effectiveness analysis in which the outcomes are considered to be identical or clinically equivalent. In this case, the analysis defaults to selecting the lowest-cost treatment alternative. Cost-utility analysis is another special case of cost-effectiveness analysis in which the value of the outcome is adjusted for differences in patients preferences (utilities) for the outcomes. Cost-utility analyses are most appropriate when quality of life is a very important consideration in the therapeutic decision. 

The Bauer/Grossmann interpretation of Marx s reproduction schema can be contrasted with our alternative perspective in which the role of money provides the focus of analysis. For Kalecki (1991c 241), it is capitalist investment and consumption decisions which determine profits, and not vice versa . In the Grossmann approach, however, capitalist consumption is a residual left over once capitalists have decided their production of surplus value, out of which new constant and variable capital are allocated. The capitalist consumption portion of surplus value is not determined by the amount of money advanced at the start of the production period, but by the portion left once production has been completed. 

Simple breakeven analysis is quite useful for getting a ballpark sense of when a given investment will start to payoff, but more sophisticated analysis will take account of the alternative uses of money and the fact that a dollar today is worth more than a dollar tomorrow. 

Neutron activation analysis (NAA) with a rapid radiochemical separation has been the method generally used in recent years, but requires substantial investment, has high operating cost and limited availability. Modem flameless atomic absorption (AAS) instruments provide sensitivity approaching that of NAA and offer a viable alternative for the detection of firearms discharge residue. 

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