Conventional investment appraisal techniques such as net present value analysis often does not capture the full strategic benefits of a project in terms of either features of a project that allow risk to be managed or features that allow further follow-on gains to be made. For example, a situation may exist where a project is easy to abandon, or uses assets that are easy to switch to another use if the project fails. This abandonment/redeployment option adds value to a project because it limits the project’s downside risk.

With this project Charlie Co could negotiate a get-out clause which gives it the right to sell the project back to the Government at a later date at a pre-agreed price. Alternatively, it could build facilities in such a way that it can redeploy them to other activities, or scale the production up or down more easily and at less cost. These options give the company the opportunity to step out of a project at a future date, if uncertainties today become negative outcomes in the future.

Another type of real option is the option to delay. A project can be structured to allow a company to react to improved information about the prospects of the project e.g., by staggering the capital expenditure over a period of time instead of investing in one block at the start of the project.

In the situation which Charlie Co is considering, the initial exploration rights may give it the option to delay the decision of whether to undertake the extraction of oil and gas to a later date. In that time, using previous knowledge and experience, it can estimate the quantity of oil and gas which is present more accurately. It can also use its knowledge to assess the variability of the likely quantity. Charlie Co may be able to negotiate a longer timescale with the Government of Ireland for undertaking the initial exploration, before it needs to make a final decision on whether and how much to extract.

Finally, some projects may create an option to expand into other areas using the benefit of the experience gained during the project. For example, Charlie Co can explore whether or not applying for the rights to undertake this exploration project could give it priority in terms of future projects, perhaps due to the new knowledge or technologies it builds during the current project. These opportunities would allow it to gain competitive advantage over rivals which, in turn, could provide it with greater opportunities in the future, but which are uncertain at present.

Charlie Co can use the Black-Scholes option valuation formulae to assess the value of any real options associated with the project. This value can be added to the conventional net present value computation to give a more accurate assessment of the project’s value.

The option price formula used with investment decisions is based on the BSOP model. The BSOP model makes a number of assumptions as follows:

i. The option is assumed to be exercised at a specific point in time (i.e., a European option); this may not be true in reality e.g., an option to redeploy may be exercised at any time.

ii. The BSOP model uses the risk-free rate of interest. It is assumed that this is known and remains constant, which may not be the case where the time it takes for the option to expire is long;

iii. The most significant drawback of the BSOP model is the estimation of the standard deviation of the price of the asset. The BSOP model assumes that volatility can be assessed and stays constant throughout the life of the project; again, with long-term projects these assumptions may not be valid.

iv. The BSOP model assumes that the underlying asset can be traded freely. This is probably not accurate where the underlying asset is an investment project.

These assumptions mean that the value based around the BSOP model is indicative and not definitive.

The value of a firm can be thought of in these terms:

1. If the firm fails to generate enough value to repay its loans, then its value = 0; shareholders have the option to let the company die at this point.
2. However, if the firm does generate enough value, then the extra value belongs to the shareholders and in this case, shareholders can pay off the debt (this is the exercise price) and continue in their ownership of the company.

Therefore, the BSOP model can be applied because shareholders have a call option on the business. The protection of limited liability creates the same effect as a call option because there is an upside if the firm is successful, but shareholders lose nothing other than their initial investment if it fails. So, the value of a company can be calculated as the amount that you would pay as a premium for this call option.

If, at expiry of the debt, the value of the company is greater than the face value of debt, then the option is in-the-money, otherwise if the value of the firm is less than the face value of debt, then the option is out-of-the-money and equity is worthless.

Prior to expiry of the debt, the call option (value to holders of equity) will also have a time value attached to it.

The BSOP model can be used to assess the value of the option to the equity holders, the value of equity, which can consist of both time value and intrinsic value if the option is in-the-money, or just time value if the option is out-of-money.

Within the BSOP model, N(d₁), the delta value, shows how the value of equity changes when the value of the company’s assets changes. N(d2) depicts the probability that the call option will be in-the-money (i.e., have intrinsic value for the equity holders).

Debt can be regarded as the debt holders writing a put option on the company’s assets, where the premium is the receipt of interest when it falls due and the capital redemption. If N(d₂) depicts the probability that the call option is in-the-money, then 1 – N(d₂) depicts the probability of default.

Therefore, the BSOP model and options are useful in determining the value of equity and default risk.

Option pricing can be used to explain why companies facing severe financial distress can still have positive equity values. A company facing severe financial distress would presumably be one where the equity holders’ call option is well out-of-money and therefore has no intrinsic value. However, as long as the debt on the option is not at expiry, then that call option will still have a time value attached to it. Therefore, the positive equity value reflects the time value of the option, even where the option is out-of-money, and this will diminish as the debt comes closer to expiry. The time value indicates that even though the option is currently out-of-money, there is a possibility that due to the volatility of asset values, by the time the debt reaches maturity, the company will no longer face financial distress and will be able to meet its debt obligations.

According to the BSOP model, the value of an option is dependent on five variables: the value of the underlying asset, the exercise price, the risk-free rate of interest, the implied volatility of the underlying asset, and the time to expiry of the option. These five variables are input into the BSOP formula, in order to compute the value of a call or a put option. The different risk factors determine the impact on the option value of the changes in the five variables, and collectively these are known as the ‘Greeks’.

In the case of a call option the option will be more valuable if:

• The exercise price is lower; or
• The value of the underlying asset, the risk-free rate of interest, the volatility, or the time period is higher.

The ‘Vega’ determines the sensitivity of an option’s value to a change in the implied volatility of the underlying asset. Implied volatility is what the market is implying the volatility of the underlying asset will be in the future. The value of an option will rise as volatility increases because it will increase the potential extent to which an option may be in-the-money which will benefit the option holder – but if an option is out-of-the-money it will simply not be exercised and therefore if the extent to which an option is out-of-the-specifmoney rises then it has no impact on the option holder. Therefore, as the ‘Vega’ increases, so will the value of the option.

1. Net present value

Base case NPV = $0.707m (positive but marginal)

Workings:

1. Sales

2. Costs

Tutorial note. Remember that only specific fixed costs should be included in the NPV calculation – allocated fixed costs are not relevant.

3. Capital allowances

Capital allowances (tax-allowable depreciation) are available on plant and machinery at a rate of 25% (straight-line basis)

Annual capital allowance will be 25% of $3 – 0.4m = $0.65m Tax benefit = $0.65m × 25% = $0.163m p.a.

Tutorial note. You could also have assumed that capital allowances were $0.75m in the first 3 years and $0.35m in the final year. You would gain full credit for this.

4. Working capital

Tutorial note. It is only the extra working capital required each year that should be included in the NPV calculation. Don’t be tempted to include the full 15% of each year’s sales revenue as the annual working capital requirement. You should only include the difference between this year’s working capital requirement and that required for next year.

Working capital requirement

5. Discount factor

We assume that the ungeared cost of equity will be used to discount the project as this represents the business risk associated with this new venture.

K_e = + (1– T) (–k_d)

V_d = $40m x 0.9488 = $37.952m (where 0.9488 represents the fraction of the par value at which the debt is trading)

V_e = 15m shares x $2.53 = $37.95m

We are not told the ratio of V_d to V_e therefore we will assume that it is 1.

14 =  + 0.72 × ( – 4.5) × 1

14 = 1.72    – 3.24

= 10.02% (say 10%)

Tutorial note. You could also have estimated the discount rate by calculating the asset beta and then using that to calculate the cost of equity.

Financing side effects

Issue costs (4%) are on the gross (i.e., total) finance required which is the time 0 project cash flow of $14.488m divided by 96% (1 minus 4% issue costs) = $15.092m. The subsidy benefit of 2% is available on 80% of the project finance ($14.488m) and needs to be multiplied by 1 minus the tax rate to capture the after-tax effect.

When the side effects of financing are taken into consideration the project looks more attractive. The NPV is less marginal and the project is likely to be accepted.

Tutorial note. You might have included the issue costs in the funds borrowed. This would still give you the full credit of marks.

6. Tax shield

Tabuki Co can borrow at 300 basis points above the 5-year government debt yield rate of 4.5% – that is, 7.5%.

The Government has offered Tabuki a subsidised loan of up to 80% of the funds required ($14.488m) at a rate of 200 basis points below Tabuki’s borrowing rate of 7.5% (that is, 5.5%).

Annual tax relief

Tutorial note. Instead of using 4.5% to discount the tax relief, you could have used 7.5% as this is Tabuki’s normal borrowing rate and reflects its normal risk.

Appropriateness of the evaluation method

APV can be used when the impact of debt financing is considerable. As can be seen from the calculations above, the side effects of debt financing are significant and are shown separately rather than being integrated into the cost of capital. Base case NPV is marginal but when the financing side effects are taken into consideration the project becomes much more acceptable (NPV is increased by more than 100% even after issue costs have been deducted).

Assumptions

Some of the assumptions made in (a) above are quite general.

1. Cash flows occur at the end of the year (unless otherwise specified).
2. The feasibility study is treated as a sunk cost.
3. We have assumed that the five-year debt yield is equivalent to the risk-free rate.
4. Annual reinvestment needed on plant and machinery is equal to the tax-allowable depreciation.

However, other assumptions were made that warrant further discussion.

1. working capital represents part of the funds borrowed but subsequent increments will be financed by the project itself. The company may not have the necessary funds at the start of the project to finance the working capital. Therefore, it is reasonable to include the required amount in the initial borrowings. However, the company should assess whether it is reasonable to expect Initial the project to fund the incremental requirements, as these represent quite large amounts.
2. Aslam Co’s ungeared cost of equity is used as it is assumed to represent the business risk attributable to the new venture and is calculated on the assumption that Modigliani and Miller’s Proposition 2 holds.
3. This assumes that the ungeared cost of equity does not include financial distress costs which may or may not be reasonable. It is difficult to determine an accurate ungeared cost of equity in practice and the figure used is based on a company in a similar, but not identical, line of business to the new venture. However, it is likely that such approximations of the cost of capital are acceptable given that the discount rate tends to be the least sensitive factor in investment appraisal.

A free trade area like the EU aims to remove barriers to trade and allow freedom of movement of production resources such as capital and labour within the EU. The EU also has a common legal structure across all member countries and tries to limit any discriminatory practice against companies operating in these countries.

The EU also erects common external trade barriers to trade against countries which are not member states.

Lisa Co may benefit from operating within the EU in a number of ways.

It may be protected from non-EU competition because companies outside the EU may find it difficult to enter the EU markets due to barriers to trade.

A common legal structure should ensure that the standards of food quality and packaging apply equally across all the member countries. This will reduce compliance costs for Lisa, which may be an important issue for a small company with limited financial resources.

Having access to capital and labour within the EU may make it easier for the company to set up branches inside the EU, if it wants to. The company may also be able to access any grants which are available to companies based within the EU.

Project Marx internal rate of return (IRR)

Net present value (NPV): €2,293,000 approximately using a cost of capital of 10%

NPV = € (1,310,000)

IRR = 10% + 2,293/ (2,293 + 1,310) x 10% approximately = 16.4%

Modified internal rate of return (MIRR)

Total present values (PVs) of inflows from time 1 to 5 at 10% discount rate = outlay + NPV of project = €11,840,000 + €2,293,000 = €14,133,000

MIRR (using formula provided) = ^1/n x (1+r_e)-1

MIRR= ^1/5 x (1+0.1)-1= 14%

Value at risk (VaR)

A 95% confidence level requires the annual present value VaR to be within approximately 1.645 standard deviations from the mean.

A 90% confidence level requires annual present value VaR to be within approximately 1.282 standard deviations from the mean.

(Note. An approximation of standard deviations to two decimal places is acceptable.)

95%, 5-year present value VaR = $400,000 x 1.645 x square root of 5 (since it is a 5-year project) = approx… €1,471,000

90%, 5-year present value VaR = $400,000 x 1.28 (approx..) x square root of 5 (since it is a 5-year project) = approx… €1,145,000

The IRR for project Karl is higher. However, where projects are mutually exclusive, the IRR can give an incorrect answer. One reason for this is that the IRR assumes that returns are reinvested at the internal rate of return, whereas NPV and the MIRR assume that they are reinvested at the cost of capital (discount rate) which in this case is 10%. The cost of capital is a more realistic assumption as this is the minimum return required by investors in a company.

The NPV and the MIRR both indicate that project Marx would create more value for Lisa Co.

Therefore, based purely on cash flows, project Marx should be accepted due to the higher NPV and MIRR, as they give the theoretically correct answer of the value created.

The VaR provides an indication of the potential riskiness of a project. For example, if Lisa Co invests in project Marx, then it can be 95% confident that the PV will not fall by more than €1,471,000 over its life. Hence the project will still produce a positive NPV. However, there is a 5% chance that the loss could be greater than €1,471,000. With project Karl, the potential loss in value is smaller and therefore it is less risky.

When risk is also taken into account, the choice between the projects is not clear cut and depends on Lisa Co’s attitude to risk and return. Project Marx gives the higher potential NPV but is riskier, whereas project Karl is less risky but gives a smaller NPV. This is before taking into account additional uncertainties such as trading in an area in which Lisa Co is not familiar.

It is therefore recommended that Lisa Co should only proceed with project Marx if it is willing to accept the higher risk and uncertainty.

There are a number of possible legal risks which Lisa Co may face:

1. The countries where the product is sold may have different legal regulations on food preparation, quality and packaging.
2. The legal regulations may be laxer in countries outside the EU but Lisa Co needs to be aware that complying only with the minimum standards may impact its image negatively overall, even if they are acceptable in the countries concerned.
3. There may be trade barriersg., import quotas in the countries concerned which may make it difficult for Lisa Co to compete.
4. The legal system in some countries may not recognise the trademarks or production patents which the company holds on its packaging and production processes. This may enable competitors to copy the food and the packaging.
5. Different countries may have different regulations regarding product liability from poorly prepared and/or stored food which cause harm to consumers.

Possible mitigation strategies:

1. Lisa Co needs to undertake sufficient research into the countries’ current laws and regulations to ensure that it complies with the standards required. It may even want to ensure that it exceeds the required standards to ensure that it maintains its reputation.
2. Lisa Co needs to ensure that it also keeps abreast of potential changes in the law. It may also want to ensure that it complies with best practice, even if it is not the law yet. Often current best practices become enshrined in future legislation.
3. Strict contracts need to be set up between Lisa Co and any agents it uses to transport and sell the food. These could be followed up by regular checks to ensure that the standards required are maintained.

(Note. Credit will be given for alternative, relevant discussion for parts (a) and (c).)

Use the information for Ben Co to estimate the component project’s asset beta. Then use Kappa Co’s capital structure to estimate the project’s equity beta and WACC. It is assumed that the beta of debt is zero.

Ben Co MV_e = $1.20 × 400m shares = $480m

Ben Co MV_d = $96m

Ben Co portfolio asset beta = 1.40 × $480m/ ($4

80m + $96m × (1 – 0.25)) = 1.217

Ben Co asset beta of other activities = 1.25 × $360m/ ($360m + $76.8m × (1 – 0.25)) = 1.078

1.217 = component asset beta × 0.25 + 1.078 × 0.75

Component asset beta = (1.217 – (1.078 × 0.75))/0.25 = 1.634

Component equity beta based on Kappa Co capital structure:

1.634 × [($18m + $3.6m × 0.75)/$18m] = 1.879

Using CAPM

K_e = 3.5% + 1.879 × 5.8% = 14.40%

WACC = (14.40% × $18m + 4.5% × $3.6m)/ ($18m + $3.6m) = 12.75%, say 13%.

Process Mark

 IRR is approximately 13% + (1,490/ (1,490 – 663)) × (20% – 13%) = 25.6%

(3 marks)

Tutorial note. You are unlikely to have used these exact discount rates, in which case you may reach a different conclusion to the one below. As long as your conclusion is based on your calculations you will gain credit, whichever discount rates have been used.

MIRR

MIRR = ^1/n x (1+r_e)-1

Pv_i= PV of investment phase = 3,800

PV_r = PV of return phase = 3,800 + NPV of 1,490 = 5,290

MIRR = ^1/4 × (1+0.13)- 1= 0.227 or 22.7%

(1 mark)

IRR assumes that positive cash flows are reinvested and earn a return at the same rate as the project’s IRR. The MIRR assumes that positive cash flows are reinvested at the cost of capital. The assumption is more reasonable and the result produced is consistent with the net present value. Process Zeta should be adopted as a result, although the difference between the two projects is not significant.

(3 marks)

A 99% confidence level requires the VaR to be within 2.33 standard deviations from the mean, based on a single tail measure.

Annual VaR = 2.33 × $800,000 = $1,864,000

Five-year VaR = $1,864,000 × 5^0.5 = $4,168,031

This means that Ben Co can be 99% confident that the cash flows will not fall by more than $1,864,000 in any one year or $4,168,031 in total over the 5-year period. This means that it can be 99% sure that the returns will be at least ($2,200,000 – $1,864,000) = $336,000 each year. The company can also be 99% sure that the total 5-year returns will be at least ($11,000,000 – $4,168,031) = $6,831,969. There is only a 1% chance that the returns will be less than $336,000 each year or $6,831,969 in total.

Risk is most commonly dealt with by using expected value analysis, which involves assigning probabilities to all possible outcomes. The major drawback is that the assignment of probabilities is highly subjective. This method is also not suitable for a one-off project, as it may give an expected value that is not possible. It also does not indicate the maximum loss or the probability of making a loss, factors which will impact managers’ decision making when they consider project risks.

Uncertainty can be dealt with using a variety of methods. One of these is sensitivity analysis. This involves altering the variables in the investment appraisal and seeing how this affects the outcome. The main drawbacks are that variables are looked at in isolation, but in reality, they may be interdependent and that it does not assess the likelihood of the changes in the variables occurring.

Payback and discounted payback can be used to determine how long it will take to recover the initial cost of the investment. The major drawback is that any cash flows after payback has occurred are ignored.

Before implementing proposal:

Cost of equity = 4% + (1.1 × 6%) = 10.6%

Cost of debt = 4% + 0.90 = 4.9%

Market value of debt (MV_d)

($5.20 × 1/1.049) + ($5.20 × 1/1.049²) + ($105.20 × 1/1.049³) = $100.82

Total value = $42 million × 100.82/100 = $42,344,400

Market value of equity (MV_e)

As stated in the question the free cash flow to equity model provides a reasonable estimate of the market value of the company.

Assumption

The growth rate can be estimated using the rb model. It is assumed that the retained free cash flows to equity will be invested to generate a return at least equal to the shareholders’ required rate of return.

R = 10.6% and b = 0.4

g= rb = 10.6% × 0.4 = 4.24%

MV_e =  = 2.6m × 1.0424/ (0.106 – 0.0424) = $42,614,000 (rounded)

The proportion of MV_e to MV_d is close to 50:50, which will be used here to simplify the calculations.

WACC = 10.6% × 0.5 + 4.9% × 0.5 × 0.8 = 7.3%

(8 marks)

After implementing the proposal:

The estimate of the asset beta for Mandarina Co is:

β_a= 1.1 × 0.5/ (0.5 + 0.5 × 0.8) = 0.61

Asset beta for hotel services

It has been assumed that Mandarina Co’s asset beta is a weighted average of the average property company beta and the hotel services beta.

Therefore:

0.61 = (Asset beta (hotel services) × 0.6) + (0.4 × 0.4)

0.45 = Asset beta (hotel services) × 0.6

Asset beta (hotel services) = 0.75

Equity beta for Mandarina Co, hotel services only

MV_e is unchanged as stated in the question.

MV_e = $42,614,000

k_d = 4 + 0.6 = 4.6%

MV_d = ($5.20 × 1/1.046) + ($5.20 × 1/1.046²) + ($105.20 × 1/1.046³) = $101.65

Total value = $12.6 million × 101.65/100 = $12,808,000 (rounded)

Equity beta calculation

0.75 = β_e× (42,614/ (42,614 + 12,808 × 0.8))

0.75 = β_e × 0.806

β_e = 0.93

Hotel services cost of equity and WACC

k_e = 4% + 0.93 × 6% = 9.6%

WACC = 9.6% × (42,614/ (42,614 + 12,808)) + 4.6% × 0.8 × (12,808/ (42,614 + 12,808)) = 8.2%

(7 marks)

Comment

The proposal will increase the asset beta of Mandarina Co because the hotel services industry has a higher business risk than a business that also owns hotels. However, the equity beta and the cost of equity are both lower because of the reduction in the level of debt. This is because the reduction in debt means that the financial risk of Mandarina Co is lower. However, the WACC increases because this lower debt level means there is less cheap debt in the financing mix. As a result, the board of directors’ assertion that the lower level of debt will reduce WACC is incorrect.

(Max 5 marks)

The assumption that the market value of equity will not change is unlikely to hold in reality. The change in the growth rate of free cash flows and sales revenue and the changes in the business and financial risks of the new business are all likely to have an effect.

In estimating the asset beta of Mandarina Co for offering hotel services only there has been no consideration of the change in business risk as a result of renting rather than owning the hotels. A revised asset beta should be estimated to reflect the change in business risk.

The market value of equity has been used to estimate the post-implementation equity beta and cost of equity of the business. However, the market value of equity is dependent on the cost of equity, which is itself dependent on the equity beta. Therefore, both the cost of equity and the market value of equity will change as a result of the implementation of this proposal.

The number of put options to be purchased depends on the hedge ratio, which in turn is determined by the option’s delta. We can estimate delta using N(–d1).

Number of put options needed = 200,000 shares/ (0.5239 × 1,000 shares) = 382 contracts

Possible reasons for the suggestions made by each of the three managers.

i. No hedging at all

This argument is based on the theory that corporate risk should not be hedged. This theory states that, where a company holds a well-diversified portfolio and securities are priced correctly, unsystematic risk will be at least reduced to a minimal level or eliminated completely. There is, therefore, no apparent gain to shareholders of any further hedging or management of corporate risk (that is, unsystematic risk cannot be reduced further). Should hedging take place in a perfect market it is likely that shareholders will actually lose out, as the benefits derived from hedging will be outweighed by the costs of doing so.

In an imperfect market, however, shareholders are more likely to benefit from hedging. By reducing the volatility of the firm’s earnings, cash flows are likely to increase, which will increase shareholders’ wealth. Such a situation is likely to arise

• If stable earnings increase the certainty of being able to pay for future investments which would encourage a more stable investment policy
• If tax rates are increasing
• If a high volatility of earnings could lead to financial distress for the company

None of the above reasons for hedging appears to exist for Mango Co and the case for hedging seems to be weak. Mango is a large company with numerous investments; therefore, it is unlikely that reducing the volatility of one such investment will have a significant effect on its cash flows.

ii. Sell Rosy Co’s shares in order to eliminate risk of a fall in share price

This is based on the assumption that Mango will be protected from a fall in Rosy’s share price if it gets rid of the shares in Rosy. However, there are a few issues with this proposal.

It is assumed that Mango holds shares in Rosy as an investment and generates a return greater than the risk-free rate. If Mango sells these shares, an alternative investment offering similar returns should have to be found for the surplus funds, to prevent a reduction in Mango’s shareholder value. If such investments are not available, the shares should not be sold.

Another issue is the potential effect on Rosy’s share price if Mango does ‘dump’ a large number of shares on the market. Managers have to ask whether they are likely to be able to sell such a large proportion of Rosy’s shares, although there is the chance that investors want to take the opportunity of purchasing shares at a lower price now, in the expectation that the price will increase again following the projected period of uncertainty.

iii.Hedge the investment using an appropriate derivative product

If this proposal was undertaken, Mango would be required to purchase 382 OTC put options from the bank (see calculations above). This could prove to be expensive, as Mango will have to pay a premium on each option for the flexibility of having the right, but not the obligation, to exercise the options. Should the option not be exercised, Mango will have suffered the cost of the premiums for no reason. However, if the options are exercised, Mango will have protected itself against downside movements in the share price.

Hedging using options involves several risks. Delta is not stable, which means that the number of options that should have been taken out may change (thus Mango may not be fully protected). Option values also change, the closer they come to the exercise date (measured by theta) and the underlying asset’s volatility changes (measured by vega).

Despite the risks associated with derivative products, a stable hedging policy can be used to reduce agency conflicts between shareholders and managers. A single hedging transaction is unlikely to have much impact, but it is important to maintain a consistent approach to hedging against investment risks. This protects not only shareholders’ wealth but also managers, who may not be as well diversified as the shareholders.

iv. Do not hold any equity investments at all

Yug may be correct that Mango Co should not hold equity investments. This is not a core area of business for Mango Co and it may be best not to focus on it and therefore sell all the shares. However, it is the job of the treasury department to manage excess funds and liquidity and it may be that the equity holdings deliver a valuable dividend stream which contributes to a healthy cash flow for the business. The treasury department will be able to show if their investment choices outperform the market return.

There is no easy way to justify or discourage hedging. Each case should be examined on its individual merits, but it is important for a company to have a risk management strategy on which such decisions can be based.

Financial impact of option to delay

First of all, we calculate the present value (PV) of the project without the option to delay.

NPV = $(2.98) m

Without the option to delay the project would be rejected.

Option to delay – use the Black-Scholes model to value this option

P_a= current value of the project (that is the PV of its cash inflows)

=$18.28m + $11.86m + $5.93m + $2.68m

= $38.75m

P_e= ‘exercise price’ of the project (that is, the cost of production etc that can be delayed) = $35m

t = exercise date (that is, when the exercise price is paid) = 2 years

r = risk-free rate = 3.5%

s = standard deviation = 0.3

d₁ = [ln (38.75/35) + (0.035 + 0.5 × 0.3²) × 2]/ [0.3 × 2] = 0.62

d₂ = 0.62 – (0.3 × 2) = 0.20

Using the normal distribution tables:

N(d¹) = 0.5 + 0.2324 = 0.7324

N(d²) = 0.5 + 0.0793 = 0.5793

Value of option to delay = (38.75 × 0.7324) – (35 × 0.5793 × e ^{(-0.035 × 2)}) = $9.127m

Total value of project = $9.127m – $2.98m = $6.147m

The project would therefore be accepted with the option to delay included.

Implications of the results

The option to delay the project gives management time to consider and monitor the potential investment before committing to its execution. This extra time will allow management to assess the popularity of similar launches and also to monitor competition. The success of the film will be heavily reliant on the marketing campaign launched by the film’s promoters prior to its release – management will be able to monitor the extent of this campaign before committing to an expensive (and potentially unsuccessful) project.

However, the calculations of the value of the option to delay are subject to several limiting assumptions, primarily the volatility of the cash flows. The value of the option to delay ($9.127m) is not an exact figure but rather an indication of how much management would value the opportunity to delay. The result shows that management should not dismiss the project immediately, despite the current negative NPV.

There may be other options embedded within the project. The technology used to develop the game may be used for other projects in the future (option to redeploy). Alternatively, the project could lead to follow-on projects if the film is successful enough to generate sequels.

The value of the option depends on the following variables.

i. The price of the security

A decrease in the price of the security will mean that a call option becomes less valuable. Exercising the option will mean purchasing a security that has a lower value.

ii. The exercise price of the option

A decrease in the exercise price will mean that a call option becomes more valuable; the profit that can be made from exercising the option will have increased.

iii.Risk-free rate of return

A decrease in the risk-free rate will mean that a call option becomes less valuable. The purchase of an option rather than the underlying security will mean that the option holder has spare cash available which can be invested at the risk-free rate of return. A decrease in that rate will mean that it becomes less worthwhile to have spare cash available, and hence to have an option rather than having to buy the underlying security.

iv. Time to expiry of the option

A decrease in the time of expiry will mean that a call option becomes less valuable, as the time premium element of the option price has been decreased.

v. Volatility of the security price

A decrease in volatility will mean that a call option becomes less valuable. A decrease in volatility will decrease the chance that the security price will be above the exercise price when the option expires.

When making decisions, following investment appraisals of projects, net present value assumes that a decision must be made immediately or not at all, and once made, it cannot be changed. Real options, on the other hand, recognise that many investment appraisal decisions have some flexibility.

For example, decisions may not have to be made immediately and can be delayed to assess the impact of any uncertainties or risks attached to the projects. Alternatively, once a decision on a project has been made, to change it, if circumstances surrounding the project change. Finally, to recognise the potential future opportunities, if the initial project is undertaken, like the Migu Project.

Real options give managers choices when making decisions about whether or not to undertake projects, by estimating the value of this flexibility or choice. Real options take into account the time available before a decision, on a project, has to be made, and the risks and uncertainties attached to the project. It uses these factors to estimate an additional value which can be attributable to the project. Real options view risks and uncertainties as opportunities, where upside outcomes can be exploited, and a company has the option to disregard any downside impact.

By incorporating the value of any real options available into an investment appraisal decision, Imoni Co will be able to assess the full value of a project.

b. Report to the board of directors (BoD), Imoni Co

Introduction

This report assesses whether or not the Agro Project should be undertaken based on its value from an initial net present value (NPV) calculation, and then taking into account the options provided by the offer from Honey Co and the Migu Project. As part of the assessment, a discussion of the assumptions and their impact on the assessment is provided.

Assessment

The value of the Agro Project based on just the initial NPV is a small negative amount of $(6,000) approximately (appendix 1). This would indicate that the project is not worth pursuing, although the result is very marginal. The offer from Honey Co, and the Migu Project, using the real options method, gives an estimated value of $17,668,000 (appendix 2), which is positive and substantial. This indicates that the Agro Project should be undertaken.

Assumptions

The following assumptions have been made when calculating the values in appendices 1 and 2.

• Since the Agro Project is in a different industry to Imoni Co’s current activities, the project-specific, risk-adjusted cost of capital of 11% based on Honey Co’s asset beta is used. It is assumed that Honey Co’s asset beta would provide a good approximation of the business risk inherent in drone production.
• It is assumed that all the variables used to calculate the values of the projects in appendices 1 and 2 are correct and accurate. Furthermore, it is assumed all the variables such as inflation rates, tax rates, interest rates and volatility figures, remain as forecast through the period of each project. It is also assumed that the time periods related to the projects and the offer from Honey is accurate and/or reasonable.
• The Black-Scholes option pricing (BSOP) model is used to estimate the real option values of the Migu Project and the Honey Co offer. The BSOP model was developed for financial products and not for physical products, on which real options are applied. The BSOP model assumes that a market exists to trade the underlying project or asset without restrictions, within frictionless financial and product markets.
• The BSOP model assumes that the volatility or risk of the underlying asset can be determined accurately and readily. Whereas for traded financial assets this would most probably be reasonable, as there is likely to be sufficient historical data available to assess the underlying asset’s volatility, this is probably not going to be the case for real options. For large, one-off projects, there would be little or no historical data available. Volatility in such situations would need to be estimated using simulation models, such as the Monte-Carlo simulation, with the need to ensure that the model is developed accurately and the data input used to generate outcomes reasonably reflects what is likely to happen in practice.
• The BSOP model assumes that the real option is a European-style option which can only be exercised on the date when the option expires. In some cases, it may make more strategic sense to exercise an option earlier. The real option is more representative of an American-style option which can be exercised before expiry. Therefore, the BSOP model may underestimate the true value of an option.
• Real options models assume that any contractual obligations involving future commitments made between parties will be binding, and will be fulfilled. For example, it is assumed that Honey Co will fulfil its commitment to purchase the project from Imoni Co at the start of the third year for $30 million and there is therefore no risk of non-fulfilment of that commitment.
• The BSOP model does not take account of behavioural anomalies which may be displayed by managers when making decisions.

Conclusion

The initial recommendation is that the Agro Project should be undertaken when the offer from Honey Co and going ahead with the Migu Project are included. Taken together, these result in a significant positive NPV. However, one or more of the above assumptions may not apply and therefore NPV value is not a ‘correct’ value. Instead, the appendices provide indicative value which can be attached to the flexibility of a choice of possible future actions which are embedded with the Agro Project and indicate that it should be undertaken.

Report compiled by:

Date

(Note: Credit will be given for alternative and valid discussion comments)

(Max 10 marks)

APPENDICES:

Appendix 1 (Part (b) (i)):

Net present value computation of the Agro Project before incorporating the offer from Honey Co and the financial impact of the Migu Project. All figures are in $000s.

Approximate net present value of the project = $(6,000)

Workings:

Working 1 (w1): Sales revenue

Working 2 (w2): Variable costs

Working 3 (w3): Tax

(Max 12 marks)

Appendix 2 (Part (b) (ii):

Migu Project: Asset value

Asset value of Migu Project of $46,100,000 is estimated as present value of future cash flows related to the project:

$70,000,000 × 1.11–4, where $70,000,000 = $60,000,000 + $10,000,000.

Honey Co offer, initial variables used to calculate the d₁, d₂, N(d₁) and N(d₂) figures:

Asset value (P_a) = $16,959,000 + $19,488,000 = $36,447,000 (cash flows foregone)

Exercise price (P_e) = $30,000,000

Exercise date (t) = 2 years

Risk-free rate (r) = 2.30%

Volatility (s) = 30%

Value of Honey Co offer

Value of Honey Co’s offer

Call value: $36,447,000 × 0.7821 – $30,000,000 × 0.6387 × e ^{(–0.023 × 2)} = $10,205,640

Honey Co’s offer is equivalent to a put option.

Put value: $10,205,640 – $36,447,000 + $30,000,000 × e ^{(–0.023 × 2)} = $2,409,899

Estimated total value arising from the two real options Value of Migu Project: $15,258,399

Value of Honey Co’s offer: $2,409,899

Estimated total value from the two real options: $2,409,899 + $15,258,399 = $17,668,298

(Max 9 marks)

(Professional marks for part (b) report 4 marks)

The overarching issue is that of conflict between the need to satisfy shareholders and the financial markets, and Imoni Co’s stated aims of bringing affordable environmentally friendly products to market and maintaining high ethical standards. This overarching issue can be broken down into smaller related issues.

Producing profitable products will presumably result in positive NPV projects, thus ensuring a continued strong share price performance. This should satisfy the markets and shareholders. However, if the products cannot be sold at a reasonable selling price because some farmers are not able to afford the higher prices, then this may compromise Imoni Co’s aim of bringing environmentally friendly products to market and making them affordable.

A possible solution is to lower production costs, by shifting manufacturing to locations where such costs are lower. Imoni Co’s BoD thus considered the move to Dunia, to lower production costs. This presumably would allow Imoni Co to reduce prices and make the drones more affordable, but at the same time ensure that the projects result in positive NPVs. However, the issue here is that supplier companies in Dunia whom Imoni Co trades with use young teenage children as part of their workforce. This may impact negatively on Imoni Co’s stated aim of maintaining high ethical standards. In fact, Imoni Co may need to rethink its links with companies it trades with in Dunia entirely. Otherwise, there is a real risk that Imoni Co could suffer from long-term loss of reputation, and this may cause substantial and sustained financial damage to the company.

Imoni Co may decide that maintaining its share price and its reputation should take the highest priority and therefore it may reach a decision that the best way to address the issue(s) is to not try to reduce costs, and to withdraw from Dunia completely. But this would prevent many agriculturalists from taking advantage of the biodegradable drones. Therefore, Imoni Co may want to explore alternative ways to meet all the aims.

Imoni Co could consider moving to another location, if this was feasible. It is not known from the narrative whether or not viable alternatives are available, but Imoni Co would need to ensure that possible alternative locations would have the infrastructure to produce the components at the same or lower costs. Imoni Co may also want to consider the softer issues; for example, it will want a good working relationship and network in the new locations which it has with the companies in Dunia. These may need to be developed and would take time and probably incur additional costs.

For these reasons, Imoni Co may decide to explore the existing production facilities in Dunia further. It is possible that the supplier companies are not exploiting the young teenage children, but are supporting their education and their families in a positive way. Stopping the relationship may jeopardise this support. Imoni Co would need to investigate the working conditions of the children and the manner in which they are rewarded and supported. It may want to consult the guardians of the young teenage children and see if there are other feasible solutions. For example, could the guardians be employed instead of the young teenage children or are they already engaged in alternative employment?

After all factors are considered, Imoni Co may conclude that the best way to achieve all its aims is to continue in Dunia and also have the production of drone components located there. If this is the case and young teenage children continue to be employed there, then Imoni Co would need a sustained public relations campaign to defend its position and demonstrate how it ensures that the teenage children have not been exploited, but are gainfully employed and receiving a good education to help them progress in life.

(Note: Credit will be given for alternative and valid discussion comments)

a. Report on the proposed theme park investment

The decision to invest in a major project must be evaluated using both financial and non-financial information. From a financial perspective the estimated net present value of the investment will provide an indicator of whether or not the project will create wealth. Non-financial considerations will include the strategic fit of the investment with the company and its future plans.

Financial evaluation

Cash flow forecasts ($ million)

The estimated net present value is ($140.05 million).

Even if the higher realisable value estimate is used, the expected net present value is still significantly negative.

Notes:

i. Receipts Year 2:

ii. Tax allowable depreciation:

It is assumed that allowances are available with a one-year lag.

No balancing allowances or charges have been estimated as the Year 5 realisable value of non-current assets has been estimated on an after-tax basis.

As the hotel business is successful, it is assumed that allowances may be used as soon as they are available against other taxable cash flows of Redman.

iii. Interest is not a relevant cash flow. All financing costs are included in the discount rate.

iv. The market research is a sunk cost.

v. Apportioned overhead is not a relevant cash flow.

vi. Although the company will save money by advertising in its existing hotels, this is not a change in cash flow as a result of the project and is not included in cash flows. (In effect the benefit from the savings is present as there is no cash outflow for advertising.)

vii. Discount rate

The current weighted average cost of capital should not be used. The discount rate should reflect the risk of the investment being undertaken; theme parks are likely to have very different risks to hotels. The cost of capital will be estimated using the risk (beta) of Queensland, as Queensland operates in the theme park sector.

The market weighted capital gearing of Queensland is:

Equity 400 × 3.86 = $1,544 m (78.3%)

Debt 460 × 0.93 = $428 m (21.7%)

As the gearing of Queensland is much less than that of Redman, the beta used to estimate the relevant cost of equity will need to be adjusted to reflect this difference in gearing.

Assuming corporate debt is virtually risk free:

Ungearing Queensland’s equity beta:

Ke = 3.5% + 1.748 (10% – 3.5%) = 14.86%

Kd is 7.5%, the cost of the new debt used for the project.

The weighted average cost of capital relevant to the new investment is estimated to be:

14.86% (0.614) + 7.5% (1 – 0.3) (0.386) = 11.15%

11% will be used as the discount rate for the investment.

Other relevant information

The financial projections used in the estimated net present value are the subject of considerable inaccuracy. It would be useful to know:

1. The accuracy of estimates of attendance levels and spending in the theme park.
2. The accuracy of price and cost changes.

• Whether or not tax rates are subject to change.

4. The accuracy of the estimate of realisable value in Year 4.
5. The accuracy of the discount rate estimate. The activities of Queensland are not likely to be of exactly the same risk as the theme park project.

For a major investment it is unwise to rely on a single estimate of expected net present value. Sensitivity analysis or simulation analysis should be used in order to ascertain the impact on the expected NPV of changes in attendance and other key cash flows. It would be better to undertake simulation analysis, based upon different possible attendance levels, costs, risk, tax rates, etc, in order to estimate a range of possible net present values, rather than use a single point value.

A crucial question is what happens to cash flows beyond the company’s four-year planning horizon. The Year 5 realisable values are asset values, not the value of the theme park as a going concern. The value as a going concern could be very different from the asset values, and have a major influence on the investment decision.

Will the theme park investment lead to future opportunities/investments (real options), for example in other theme parks or leisure activities? If so, the value of such options should be estimated, and should form part of the investment decision.

Strategic and other issues

The strategic importance of the venture to Redman must also be investigated, as this may heavily influence the final decision. Redman currently runs a successful hotel chain. It might be better to keep to its core competence in hotels rather than diversify into another sector. If new investments are sought, are there better opportunities within the hotel sector?

Any final decision must encompass all relevant non-financial factors of which little detail has been provided. Redman must be satisfied that it can recruit an appropriately skilled labour force for the theme park, and should thoroughly investigate the competition in the theme park sector, and the likely reaction of competitors if it enters this new market.

b. Briefing notes on capital structure strategy

From a corporate perspective there are two vital questions:

Can the value of a company, and hence shareholder wealth, be increased by varying the capital structure?

What effect will capital structure have on risk?

If value can be created by a sensible choice of capital structure, then companies should try to achieve an optimal, or almost optimal, capital mix, as long as this mix does not have detrimental effects on other aspects of the company’s activities.

Evidence on the importance of capital structure to a company’s value is not conclusive. There is general agreement that, as long as a company is in a tax-paying position, the use of debt can reduce the overall cost of capital due to the interest on debt being a tax-allowable expense in almost all countries. This was suggested by two Nobel prize-winning economists, Miller and Modigliani. However, high levels of debt also bring problems, and companies with very high gearing are susceptible to various forms of risk, sometimes known as the costs of financial distress. This might include the loss of cash flows because customers and suppliers are worried about the financial stability and viability of the company and move business elsewhere or impose less-favourable trading terms, or even extra costs that would exist (payments to receivers, etc) if the company was to go out of business.

A common perception about capital structure is that as capital gearing is increased, the weighted average cost of capital falls at first. However, beyond a certain level of gearing the risk to both providers of debt and equity finance increases, and the return demanded by them to compensate for this risk also increases, leading to an increase in the weighted average cost of capital. There is a trade-off between the value created by additional tax relief on debt and the costs of financial distress. Overall, there is therefore an optimal capital structure, which will vary between companies and will depend upon factors such as the nature of the company’s activities, realisable value of assets, business risk, etc. According to the theory, companies with many tangible assets should have relatively high gearing, companies with high growth, or that are heavily dependent on R & D or advertising would have relatively low gearing.

The impact of personal taxation on the capital structure decision is less clear, although investors are undoubtedly interested in after-tax returns. If personal tax treatment differs on different types of capital, then investors may have a preference for the most tax-efficient type of capital.

Not all companies behave as if there is an optimal capital structure, and on average, in countries such as the UK and USA, the average capital gearing is lower than might be expected if companies were trying to achieve an optimal structure. It must, however, be remembered that moving from one capital structure to another cannot take place overnight. The cost of debt, via interest rates, and the cost of equity, can change quite quickly. It is no surprise that companies do not appear to be at an optimal level.

Where no optimal level appears to be sought by a company, there are several suggested strategies with respect to capital structure. Among the most popular is the pecking order theory, which is based upon information asymmetry, the fact that managers have better information about their company than the company’s shareholders. This leads to a company preferring internal finance to external finance, and only using external finance in order to undertake wealth-creating (positive NPV) investments. Companies use the safest sources of finance first.

1. Internal funds (including selling marketable securities)
2. Debt
3. Equity

The amount of external finance used depends upon the amount of investment compared with the amount of internal funds, and the resultant capital structure reflects the relative balance of investment and available internal funds.

Another view is that capital structure is strongly influenced by managerial behaviour. There are potential conflicts of objectives between owners and managers (agency problems). Capital structure will be influenced by senior managers’ personal objectives, attitudes to risk, compensation schemes and availability of alternative employment. A risk-averse manager seeking security may use relatively little debt. Free cash flow (cash flow available after replacement investment) is sometimes perceived to be used by managers for unwise acquisitions/investments that satisfy their personal objectives, rather than returning it to shareholders. Many such managerial/agency aspects may influence capital structure, and this does not give clear guidance as to capital structure strategy.

No matter what the conclusion about the impact of capital structure on cash flows, it is likely that some financing packages may be more highly regarded by investors than others. For example, securities designed to meet the needs of certain types of investors (zero coupon bonds, etc), securities that are more liquid, securities with lower transactions costs, and securities that reduce conflict between parties concerned with the company, especially shareholders, managers and the providers of debt.

Conclusion

It is likely that the choice of capital structure can directly affect cash flows and shareholder wealth, but too high a level of gearing will increase risk. The impact on cash flows and corporate value of the capital structure decision is far less than the impact of capital investment decisions.

REPORT TO THE BOARD OF DIRECTORS, CLIPTON CO

EVALUATION OF WHETHER THE PRODUCTION OF X-IT SHOULD MOVE TO BRUNEI

This report evaluates the possibility of moving the production of the X-IT to Brunei from the USA. Following the initial evaluation, the report discusses the key assumptions made, the possible impact of a change in the government in Brunei after the elections due to take place shortly and other business factors that should be considered before a final decision is made.

Initially a base case net present value calculation is conducted to assess the impact of the production in Brunei. This is then adjusted to show the impact of cash flows in the USA as a result of the move, the immediate impact of ceasing production and the impact of the subsidy and the tax shield benefits from the loan borrowing.

Based on the calculations presented in the appendix, the move will result in a positive adjusted present value of just over $2.4 million. On this basis, the initial recommendation is that the production of X-IT should cease in the USA and the production moved to Brunei instead.

Assumptions

It is assumed that the borrowing rate of 5% is used to calculate the benefits from the tax shield. It could be argued that the risk-free rate of 3% could be used as the discount rate instead of 5% to calculate the present value of benefits from the tax shields and the subsidies.

In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used.

It has been assumed that many of the input variables, such as for example the tax and tax allowable depreciation rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate and will change as stated over the four-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would appropriate for Clipton Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions.

Government change

From the facts of the case, it would seem that a change of government could have a significant impact on whether or not the project is beneficial to Clipton Co. The threat to raise taxes may not be too significant as the tax rates would need to increase to more than 30% before Clipton Co would lose money. However, the threat by the opposition party to review ‘commercial benefits’ may be more significant.

Just over 40% of the present value comes from the tax shield and subsidy benefits. If these were reneged then Clipton Co would lose a significant of the value attached to the project. Also, the new government may not allow remittances every year, as is assumed in part (i). However, this may not be significant since the largest present value amount comes from the final year of operation.

Other business factors

Clipton Co should consider the possibility of becoming established in Brunei, and this may lead to follow-on projects. The real options linked to this should be included in the analysis.

Clipton Co’s overall corporate strategy should be considered. Does the project fit within this strategy? Even if the decision is made to close the operation in the USA, there may be other alternatives and these need to be assessed.

The amount of experience Clipton Co has in international ventures needs to be considered. For example, will it be able to match its systems to the Brunein culture? It will need to develop strategies to deal with cultural differences. This may include additional costs such as training which may not have been taken into account.

Clipton Co needs to consider if the project can be delayed at all. From part (i), it can be seen that a large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the commencement of the project may increase the overall value of the project.

Clipton Co needs to consider the impact on its reputation due to possible redundancies. Since the production of X-IT is probably going to be stopped in any case, Clipton Co needs to communicate its strategy to the employees and possibly other stakeholders clearly so as to retain its reputation. This may make the need to consider alternatives even more important.

Conclusion

Following from a detailed sensitivity analysis, analysis of a possible change in the government and an evaluation of the financial benefits accruing from the other business factors discussed above, the BoD can make a decision of whether to move the production to Brunei or not. This initial evaluation suggests that moving the production of the X-IT to Brunei would be beneficial.

Appendix

Brunein Project Operating Cash Flows

(All amounts in BND/$000s)

Net present value (NPV) of the cash flows from the project is approx. $2,018,000.

Workings:

(W1) Exchange rates

(W2) Sales revenue (BND 000s)

(W3) Local variable costs (BND 000s)

(W4) Imported component (BND 000s)

(W5) Local variable costs (BND 000s)

(W6) Brunei project all-equity financed discount

Clipton Co equity beta = 1.17

MVe = $2.40 × 25m shares = $60m

MVd = $40m × $1,428/$1,000 = $57.12m

Clipton Co asset beta (assuming debt is rate risk free)

1.17 × 60m/ (60m + 57.12m × 0.7) = 0.70

Project asset beta = 0.70 + 0.40 = 1.10

Project all-equity financed discount rate = 3% + 6% × 1.1 = 9.6%

(W7) Additional tax, additional contribution and opportunity cost ($000s)

(W8) Tax shield and subsidy benefits ($/BND 000s)

NPV of tax shield and subsidy benefit is approx. $1,033,000

(35 marks)

(Professional marks for part (a) 4 marks)

b. A triple bottom line (TBL) report provides a quantitative summary of performance in terms of economic or financial impact, impact on the environment and impact on social performance. TBL provides the measurement tool to assess a corporation’s or project’s performance against its objectives.

The principle of TBL reporting is that true performance should be measured in terms of a balance between economic (profits), environmental (planet) and social (people) factors; with no one factor growing at the expense of the others. The contention is that a corporation that accommodates the pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as long as the benefits that accrue from producing such a report exceeds the costs of producing it.

For example, in the case of the X-IT, reporting on the impact of moving the production to Brunei, in terms of the impact on the employees and environment in the USA and in Brunei will highlight Clipton Co as a good corporate citizen, and thereby increase its reputation and enable it to attract and retain high performing, high calibre employees. It can also judge the impact on the other business factors mentioned in the report above.

(Note: Credit will be given for alternative relevant answers)

c. Portfolio theory suggests that shareholders holding well-diversified portfolios will have diversified away unsystematic or company specific risk, and will only face risk systematic risk, i.e., risk that cannot be diversified away. Therefore, a company cannot reduce risk further by undertaking diversification within the same system or market. However, further risk reduction may occur if the diversification is undertaken by the company, on behalf of the shareholders, into a system or market where they themselves do not invest. Some studies indicate that even shareholders holding well-diversified portfolios may benefit from risk diversification where companies invest in emerging markets.

In the case of Clipton Co and the X-IT, it is not clear whether diversification benefits will result in the investment in Brunei. The benefits are dependent on the size of the investment, and on the nature of the business operations undertaken in Brunei by Clipton Co. And whether these operations mirror an investment in a significantly different system or market. If the investment is large, the operations are similar to undertaking a Brunein company. Clipton Co’s shareholders who do not hold similar companies’ shares in their portfolios may then gain risk diversification benefits from the Brunein investment.