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Financial Management

As a market leader in sports and leisure clothing industry, XYZ LTD should carefully consider any kind of investment opportunity because such a decision will inevitable effect the company’s overall performance and position on the market. If the organization plans to increase its profits or gain a larger share of the business by seizing the possibility of growth arising from the Commonwealth Championship (to be held in 2006), directors and managers should carefully and painstakingly explore all aspects of the matter before making even the smallest decision regarding this case. First, any commercial organization operates with the aim of making money. Every decision that a firm makes at various times is largely, if not solely, based on this assumption of reaching the profitable level. There is no point in performing different acts if they do not bring positive results in the future. Even though a number of issues such as fair trade, morality, government and public sector play significant role on the final decision that the organization makes, its original intentions of analyzing any possibility are of gaining profit. That’s why one has to thoroughly research the case and determine whether putting 100,000 GBP is worth the effort, which is whether this investment will bring a positive gain in two years. The following table illustrates the general approach that has to be taken in order to reach a conclusion on launching the “special athletic wear”. It’s based on simple, yet very essential, calculation of the Present Value (PV), Net Present Value (NPV) and ENPV based on the estimated Net Cash Flow and State of the Economy (Recession, Neutral, and Boom).

Year Inflow/Outflow DF(18%) PV(GBP) NPV

0 100000 1.0000 (100000)

1 45000 0.8475 38137

2 45000 0.7182 32319

3 47000 0.6086 28604

4 46000 0.5158 23727

Year Inflow/Outflow DF(18%) PV(GBP) NPV

0 100000 1.0000 (100000)

1 48000 0.8475 40680

2 40000 0.7182 28728

3 41000 0.6086 24953

4 48000 0.5158 24758

Year Inflow/Outflow DF(18%) PV(GBP) NPV

0 100000 1.0000 (100000)

1 42000 0.8475 35595

2 40000 0.7182 28728

3 34000 0.6086 20692

4 43000 0.5158 22179

The Net Present Value was found using the following approach:

PV = Cash Flow * Cost of Capital’s Corresponding Value

Net Present Value was found by adding the Present Value of corresponding years and subtracting the initial Investment of 100000 from the received sum.

As one can see from the table provided above, the NPV for every year seems to be positive. It is important and crucial, however, not to make any hasty or superficial conclusions that are based on the depicted earlier calculations only. A person who attempts to draw the closest decision on this case must carefully analyze all aspects involved in the matter. In other words, it would be wrong to overlook the significance of Cost of Capital as well as limitations of the above approach and the role these issues play in the whole deal.

First, ENPV= NPV (Recession) * 0.35 + NPV (Neutral) * 0.30 + NPV (Boom) * 0.35.

Therefore, ENPV= 7194 * 0.35 + 19119 * 0.30 + 22787 * 0.35 = 16229

Based on these analyses, a company should launch a new product due to the fact that it will be able to get a positive return on investment and, possibly, a larger share of the market after undertaking the depicted above actions.

Nevertheless, there are a number of various limitations that could greatly influence and subsequently alter the general outcome of this campaign. One should be particularly conscious of the fact that government and political situation in the world and country in particular usually have great effect on any kind of long or short-term investment. For instance, a monetary reform, adverse economical changes, and unstable social conditions will have its effect on the state of affairs in business. It is very difficult to draw the most precise forecasts of the Investments condition based on the limited amount of information that can not be easily checked or disproved in the depicted above case. These and other limitations (banking policies, socio-cultural legislation, etc.,) present an additional challenge to the directors and managers of XYZ LTD who accept the challenge of making a decision on Investing the money into Launching a New Product on the Market.

What is more, City Economic Forecaster’s services should be evaluated on the basis of relevant compatibility or Preferred Information (PI).

ENPV (XYZ LTD) = 0.25 * (-2500) + 0.45 * (-3000) + 0.30 * 12000.

Therefore, ENPV (XYZ LTD) = -625 – 1350 + 3600 = 1625

The Value of PI is obtained by the ENPV without PI and ENPV with PI. In other words, ENPV of project with market research survey results in PI = 0.30 * 12000 = 3600. On the other hand, ENPV of project without market research survey results in PI = 1625 (as calculated above). The Maximum Cost of Survey is 1975 GBP, whereas Cost of Survey is 1500 GBP. That’s why Net Benefit Survey = 475 GBP. Taking into close consideration the basis of this analysis, one can conclude that Survey offered by the company should be accepted if the discussed earlier condition will apply. In other words, the services provided by CEF are worth involving with but certain precautions and limitations that were mentioned earlier need to be closely accessed as well.

In the widest sense, Investment Appraisal is “defined as a partial equilibrium technique for estimating the net contribution of a project to some set of objectives” (Barnes 1999). One may distinguish the following three phases of project appraisal.

1. Consideration of alternatives--the single most important feature, since we should never incur a capital expenditure for a specific project before making certain that there is not a better way to achieve the same objectives.

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2. Examination of whether a proposed, independent project should be accepted.

3. Selection of a project from a set of mutually exclusive projects.

Each calls for an estimation of costs and benefits. The term Project or Investment Appraisal is also known as Cost-Benefit Analysis. The literature of managerial economics and financial management proposes a variety of different and not generally consistent indices for project selection. We will evaluate and compare these indices together with rules for project acceptance, that is, rules for the acceptance of an independent project and for the selection of a project from a set of mutually exclusive projects. The basic methodology presented in Table 2.

Concept Economic

Concept Socioeconomic

materials Fixed Costs Opportunity

direct labor Increment

Costs Social costs

costs External costs

Sunk costs Associated costs

The dissimilarities involve the use of different criteria and different prices but not the application

of different methodology.

This table presents various ways in which Costs may be classified. Knowledge of these cost components is helpful in the performance of a sensitivity analysis. The classification of costs as costs of direct materials, direct labor, and overhead is the managerial viewpoint in manufacturing enterprises. Direct materials costs are those directly related to the making of a product; they are, in general, readily measurable, of the same quantity in identical products, and used in economically significant amounts. Direct labor costs normally include the wages, salaries, and fringe benefits costs of those people processing the material. For instance, the overhead rate based on the assumption that overhead is incurred in direct proportion to the costs of direct materials is: overhead rate = (total overhead in dollars for period under consideration) / (total direct materials in dollars for period under consideration).

One can find both individualist and contextualist modes of explanation in theories of risk. Two illustrations of the individualist paradigm are described by Wildavsky and Dake (1990) as the knowledge theory and the personality theory. According to the knowledge theory, people respond to risk on the basis of the knowledge and information at their disposal. The personality theory seeks to explain risk aversive and risk tolerant choices of individuals by their personality types (which includes their propensity toward certain political ideologies). The contextualist mode of analysis begins with the setting, for example, social structure, institutional form, or cultural milieu. Contextualism is symbolized by political arenas, which are the settings that shape the power struggles underlying risk discourse.

Expected utility theory suggests that choices are coherently and consistently made by weighing outcomes (gains or losses) of actions (alternatives) by their probabilities (with payoffs assumed to be independent of probabilities). The alternative, which has the maximum utility is selected (Bell, 2000). Expected utility theory is based on three fundamental tenets about the processes that occur during decisions made under risk and uncertainty: (1) consistency of preferences for alternatives; (2) linearity in assigning of decision weights to alternatives; and (3) judgment in reference to a fixed asset position. Expected utility theory does not allow for influences on choice due to characteristics of the context of the decision. Expected utility theory predicts a preference for dominant alternatives. Alternatives, which produce greater utility will always be chosen over those which provide less utility. In addition, expected utility theory predicts that the choice is invariant, that is, the manner of presentation of the alternatives should not influence the choice. The tenet of expected utility theory holds that decision weights used to value alternatives are linear. In utility theory, the value of an alternative is determined by weighting the utilities of possible outcomes by the probability of their occurrence. The best alternative is the one which provides the highest. The decision maker is assumed to select the alternative with the highest utility.

H2: When making strategic choices, decision makers do not always choose that alternative that results in the highest utility, as determined by multiplying expected outcomes by their probabilities. Under the assumptions of utility theory, evaluation of alternatives is made from a single, unchanging reference point that is based on this comprehensive understanding of different states of wealth. Utility theory predicts that the value choice is made from a point in reference to the total asset position of the decision-maker. In choosing among alternatives decision makers do not consider the consequences of multiple transactions among choices or trades among the alternatives. This preference is expected to demonstrate risk aversion (preference for a certain alternative over a risky alternative of equal value).

J. Savage “Foundations of Statistics” appeared in 1954 and provided a powerful synthesis of many ideas surrounding uncertainty and the interpretation of probability. In particular, he linked the problem of representing uncertainty with the problem of representing rational preference and modeling rational decision. He showed that rational preference can be uniquely decomposed into subjective probability and utility. The subjective probability used in this representation is uniquely determined by the decision maker’s preferences, and the utility is determined up to the choice of a zero and a choice of units on the utility scale. Utility is therefore determined up to a positive transformation. Savage’s theory clarifies the nature of subjective probability and provides an interpretation of subjective probability in terms of observable preference behavior. It also gives us a fully developed quantitative model of what rational decision is. It tells us when we should expect that all rational people will agree, and when we must admit that rational people may hold differing opinions. According to Savage, we “should choose the act with the best expectation” (Savage 1999). Where S denotes the set of all states, the expectation of an act is Expectation of act = ?s?S p(s) ? consequence of act in s. The expected utility is calculated with a subjective probability that is uniquely determined, and utility is calculated with a utility function on consequences that is unique up to a positive transformation. The depicted above risk theories are merely guidelines or instructions on how to act in various situation but they do not provide one with definite answer what solution or choice could prove to be the best or least risky. One has to make the most out of these theoretical knowledge because practical implementation of these cognitive variations usually proves to be totally different.

Barnes, J. (1999). “Cognitive Biases and Their Impact on Strategic Planning.” Strategic Management Journal 5: 129-137.

Bell, D., H. Raiffa, and A. Tversky. (2000). “Decision Making: Descriptive, Normative, And Prescriptive Interactions”. Cambridge: Cambridge University Press- reprinted edition.

Casey, J., (1994). “Buyers’ Pricing Behavior For Risky Alternatives: Encoding Processes and Reference Reversals.” Management Science 40: 730-749.

Gough, R.,(1999) “The Effect of Group Format on Aggregate Subjective Probability Distributions,” in D. Wendt and C. Viek (eds.), Utility, Probability and Human Decision Making, Dordrecht, Reidel- reprinted edition.

Hambrick, D., and P. Mason. (2000). “Upper Echelons: The Organization As A Reflection Of Its Top Managers.” Academy of Management Review 9.

Pearce, II, J., and R. Robinson, Jr. (1999). Strategic Management. Homewood, Illinois: Irwin.

Russo, J., and P. Schoemaker. (1997). Decision Traps. New York: Doubleday.

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