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Investment Projects And Evaluation Of Financing Alternatives Finance Essay

Capital budgeting is considered by many professionals as a managerial tool required for managing the collected capital of the business. The basic responsibility of the financial managers is to choose the investments in a way that it could generate good rates of return, and to decide if a particular investment should be included in the portfolio or not, through the main techniques widely used: NPV, IRR, ARR, payback period and profitability index.

The hereby paper went beyond NPV vs. IRR analysis and also used, for evaluating its four alternative investment plans, the following evaluation techniques: payback period, profitability index, and accounting rate of return.

When capital rationing is necessary, ranking projects will provide a logical starting point for determining what group of projects to accept. As we’ll see, conflicting rankings using NPV and IRR result from differences in the magnitude and timing of cash flows. The underlying cause of conflicting rankings is different implicit assumptions about the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of a project. NPV assumes that intermediate cash inflows are reinvested at the cost of capital, whereas IRR assumes that intermediate cash inflows are invested at a rate equal to the project’s IRR.

The vast majority of the financial instruments, that is 41 out of 48 (85%), are basically lending instruments. They either provide the loans themselves (37 out of 48) or they provide access, via guarantee mechanisms (4 out of 48) to loans from third parties. Driven by the shortcoming of standard lending instruments, we have begun to examine the possibility to develop alternate financial instruments that facilitate financial access, such as accessing the development and innovation structural funds.

Finally, we made a brief literature review over the capital structure decision theories and the factors affecting it.

Introduction

Gabriel Couto, Portuguese company activating in the constructions business, is developing and assessing four plans for increasing the capacity production, by purchasing specific equipment and machinery that is missing from the equipment park, needed in order to accomplish the standards and the requirements of the construction projects they are and will be involved in. The total budget is 40,000 euro and the initial investment amounts in 10,000 euro. All the plans have identical risk and the depreciation is represented on a straight line basis, while the tax basis is 40%. Each plan revenue and expenses is briefly described as follows:

Table 1: Revenue and expenses for the company’s projects

Project

Revenues/Expenses

Year 1

Year 2

Year 3

A

Revenue

21,000

-

-

Expenses

11,000

-

-

B

Revenue

15,000

17,000

-

Expenses

5,833

7,833

-

C

Revenue

10,000

11,000

30,000

Expenses

5,555

4,889

15,555

D

Revenue

30,000

10,000

5,000

Expenses

15,555

5,555

2,222

Capital Budgeting Techniques

Firms use the relevant cash flows to make decisions about proposed capital expenditures. These decisions can be expressed in the form of project acceptance or rejection or of project rankings. A number of techniques are used in such decision making, some more sophisticated than others. These techniques are the topic of this chapter, wherein we describe the assumptions on which capital budgeting techniques are based, show how they are used in both certain and risky situations, and evaluate their strengths and weaknesses.

When firms have developed relevant cash flows, they analyze them to assess whether a project is acceptable or to rank projects. As stated above, a number of techniques are available for performing such analyses. The preferred approaches integrate time value procedures, risk and return considerations, and valuation concepts to select capital expenditures that are consistent with the firm’s goal of maximizing owners’ wealth. This section focuses on the use of these techniques in an environment of certainty.

Capital budgeting represents a process of planning used to ascertain the long-term investments of a company. The long-term investment of Gabriel Couto company may be for new machinery, new plants, replacement machinery, new products and the research and development projects.

We will use one basic problem to illustrate all the techniques described in this chapter. The problem concerns the four alternative investment plans developed by Gabriel Couto, for increasing the capacity production, by purchasing specific equipment and machinery. Here we begin with a look at the three most popular capital budgeting techniques: payback period, net present value, and internal rate of return [1] .

2.1 Net Present Value (NPV)

Because net present value (NPV) gives explicit consideration to the time value of money, it is considered a sophisticated capital budgeting technique. All such techniques in one way or another discount the firm’s cash flows at a specified rate.

When NPV is used, both inflows and outflows are measured in terms of present dollars. Because we are dealing only with investments that have conventional cash flow patterns, the initial investment is automatically stated in terms of today’s dollars. If it were not, the present value of a project would be found by subtracting the present value of outflows from the present value of inflows.

The Decision Criteria

When NPV is used to make accept-reject decisions, the decision criteria are as follows:

• If the NPV is greater than €0, accept the project.

• If the NPV is less than €0, reject the project.

If the NPV is greater than €0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners.

2.2 Internal Rate of Return (IRR)

The internal rate of return (IRR) is probably the most widely used sophisticated capital budgeting technique. However, it is considerably more difficult than NPV to calculate by hand. The internal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with €0 (because the present value of cash inflows equals the initial investment). It is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

The Decision Criteria

When IRR is used to make accept-reject decisions, the decision criteria are as follows:

• If the IRR is greater than the cost of capital, accept the project.

• If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm earns at least its required return. Such an outcome should enhance the market value of the firm and therefore the wealth of its owners.

2.3 Comparing NPV and IRR Techniques

To understand the differences between the NPV and IRR techniques and decision makers’ preferences in their use, we need to look at net present value profiles, conflicting rankings, and the question of which approach is better.

Net Present Value Profiles

Projects can be compared graphically by constructing net present value profiles that depict the projects’ NPVs for various discount rates. These profiles are useful in evaluating and comparing projects, especially when conflicting rankings exist.

Using both these capital budgeting techniques and starting with the basic cash flow calculation, Gabriel Couto’s evaluation of investment plans reveals the following results:

Table 2: NPV and IRR

Plans

Cash Flow (€)

NPV 10%

NPV 35%

IRR

Year 0

Year 1

Year 2

Year 3

A

(10,000)

10,000

(€909)

(€2,593)

0%

B

(10,000)

7,500

7,500

€3,017

(€329)

32%

C

(10,000)

4,000

5,000

10,000

€5,282

(€229)

34%

D

(10,000)

10,000

4,000

2,778

€4,484

€732

42%

As such, taking in consideration the IRR indicator and the respective decision criteria, the final project plan (D) seems to be the best investment decision. Relating to the NPV indicator is more complex, from this perspective the selection differs according to the discount rate. When applying a 10% discount rate, all the three projects B, C and D could become good investment decisions, but when approaching a 35% discount rate only the final project plan (D) has a positive NPV, which makes it, from this point of view, the only project that would make a good investment decision.

2.4 Payback Period

Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash inflows. In the case of an annuity, the payback period can be found by dividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.

The Decision Criteria

When the payback period is used to make accept-reject decisions, the decision criteria are as follows:

• If the payback period is less than the maximum acceptable payback period, accept the project.

• If the payback period is greater than the maximum acceptable payback period, reject the project.

The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement, and renewal), the perceived risk of the project, and the perceived relationship between the payback period and the share value. It is simply a value that management feels, on average, will result in value-creating investment decisions.

2.5 Accounting Rate of Return

The accepted definition of the accounting rate of return is a ratio of profit to employed capital assets calculated before tax and interest and measured for a fixed period of time. Many financial analysts prefer the accounting rate of return method over other methods because it provides a useful basis for comparison of profitability and risk of various investment options. For this reason, a more pragmatic accounting rate of return definition includes reference to its utility in capital budgeting; the accounting rate of return is often used by companies to determine which of several competing projects is likely to offer the highest reward-to-risk ratio.

In our case, Gabriel Couto has to evaluate, starting with the afore-mentioned techniques, its four alternative investment plans. The results, following the given path, are the following:

Table 3: Payback period and ARR

Plans

Cash Flow (€)

Payback period

Accounting rate of return

Year 0

Year 1

Year 2

Year 3

A

(10,000)

10,000

1 year

0%

B

(10,000)

7,500

7,500

2 years

50%

C

(10,000)

4,000

5,000

10,000

3 years

90%

D

(10,000)

10,000

4,000

2,778

1 year

68%

If we evaluate our plans by taking into consideration the payback period, projects A and D seem to be the most profitable investments. However, this technique does not take into account the opportunity of cost of capital because the timing of the cash flows in the payback period (Brealey, 2007). From this perspective, we believe that this method should not be used alone in order to evaluate the best investment decision. We coupled it with the ARR indicator, which filtrated the result in such way that it eliminated the first option, awarding project plan D as the best investment decision.

2.5 Profitability Index

The profitability index is as well a technique of capital budgeting. This holds the relationship between the investment and a proposed project's payoff. Mathematically the profitability index is given by the following formula:

Profitability Index = (Present Value of future cash flows) / (Present Value of Initial investment)

The profitability index is also sometimes called as value investment ratio or profit investment ratio. Profitability index is used to rank various projects. In Gabriel Couto’s case, in order to evaluate and rank the four alternative plans, and being also in the situation when the budget constraint is 10.000 euro, we cannot wisely select a project based on IRR and NPV only. We need to evaluate the plans and their projects that have the highest value per money invested. Therefore we will analyze each project from the profitability index perspective, as shown below:

Table 4: Profitability index

Plans

Cash Flow (€)

NPV 10%

NPV 35%

Budget

Profitability index (10%)

Profitability index (35%)

Year 0

Year 1

Year 2

Year 3

A

-10.000

10.000

 

 

-909

-2593

10.000

-0,0909

-0,2593

B

-10.000

7.500

7.500

 

3017

-329

10.000

0,3017

-0,0329

C

-10.000

4.000

5.000

10.000

5282

-229

10.000

0,5282

-0,0229

D

-10.000

10.000

4.000

2.778

4484

732

10.000

0,4484

0,0732

The profitability index, formally represented as the ratio between the NPV and the initial investment shows that project C has the biggest profitability indicator in the situation of 10% discount rate and this is the project that should be chosen in under the given circumstances.

Capital Rationing Constraints

Before the famous article of Lorie and Savage (1955), limited availability of capital was not a concern in most work on capital investment modeling. Their work was very influential in attracting attention to a firm facing with a multitude of possible investment projects and a fixed capital budget. Afterwards, Weingartner (1963, 1966) formulated the Lorie-Savage problem as an integer program which maximized the NPV of project cash flows subject to capital rationing constraints.

3.1 Conflicting Rankings

Ranking is an important consideration when projects are mutually exclusive or when capital rationing is necessary. When projects are mutually exclusive, ranking enables the firm to determine which project is best from a financial standpoint. When capital rationing is necessary, ranking projects will provide a logical starting point for determining what group of projects to accept.

3.2 Real Options and Capital Rationing

A couple of important issues that often confront the financial manager when making capital budgeting decisions are (1) the potential real options embedded in capital projects and (2) the availability of only limited funding for acceptable projects. Here we briefly consider each of these situations.

Recognizing Real Options

The procedures described so far suggest that to make capital budgeting decisions, we must (1) estimate relevant cash flows and (2) apply an appropriate decision technique such as NPV or IRR to those cash flows. Although this traditional procedure is believed to yield good decisions, a more strategic approach to these decisions has emerged in recent years. Some of the more common types of real options are abandonment, flexibility, growth, and timing, as we analysed within the Appendix 1 (table 5).

3.3 Choosing Projects under Capital Rationing

Firms commonly operate under capital rationing—they have more acceptable independent projects than they can fund. Theoretically, capital rationing should not exist. Firms should accept all projects that have positive NPVs (or IRRs > the cost of capital). However, in practice, most firms operate under capital rationing. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management. Studies have revealed that management internally imposes capital expenditure constraints in order to avoid what it deems to be “excessive” levels of new financing, especially debt. Although failing to fund all acceptable independent projects is theoretically inconsistent with the goal of maximizing owner wealth, we will discuss capital rationing procedures because they are widely used in practice.

The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted. As a prerequisite to capital rationing, the best of any mutually exclusive projects must be chosen and placed in the group of independent projects. Two basic approaches to project selection under capital rationing are discussed here.

Internal Rate of Return Approach

The internal rate of return approach involves graphing project IRRs in descending order against the total dollar investment. This graph is called the investment opportunities schedule (IOS). By drawing the cost-of-capital line and then imposing a budget constraint, the financial manager can determine the group of acceptable projects. The problem with this technique is that it does not guarantee the maximum dollar return to the firm. It merely provides a satisfactory solution to capital-rationing problems.

Net Present Value Approach

The net present value approach is based on the use of present values to determine the group of projects that will maximize owners’ wealth. It is implemented by ranking projects on the basis of IRRs and then evaluating the present value of the benefits from each potential project to determine the combination of projects with the highest overall present value. This is the same as maximizing net present value, in which the entire budget is viewed as the total initial investment. Any portion of the firm’s budget that is not used does not increase the firm’s value. At best, the unused money can be invested in marketable securities or returned to the owners in the form of cash dividends. In either case, the wealth of the owners is not likely to be enhanced.

Alternative Financial Instruments

Financial market turbulence or financial stress is typically characterized by a loss of investor appetite for emerging market debt and higher borrowing costs for some or all of the following reasons: (1) reduced liquidity in secondary markets for emerging market debt; (2) higher risk premiums that (temporarily) push up borrowing costs; (3) a rise in the perceived risk of default by sovereign borrowers; (4) increase in market uncertainty, including from risks of contagion; (5) increased risk aversion among investors; and (6) increased uncertainty about future prospects of the investors (comparison available in table 6 – Appendix 2).

In such circumstances, emerging market borrowers often have adjusted their debt management strategies, and have made use of debt instruments, embodying innovative features, to maintain access to capital markets and diversify risks (Table 5). The alternative debt instruments— which include debt augmentation, time varying and state contingent instruments, structured notes, and collateralized borrowing—seek to mitigate one or more of the above concerns by changing the nature of the debt instrument, its payoff, as well the commitment of the sovereign borrower to meet its debt obligations. The use of such instruments could, however, also be undertaken at times of relative tranquility provided they are consistent with the overarching and constant goals of improving fundamentals and sound debt management and build credibility with markets.

Moreover, one financial instrument that might raise high interest to Gabriel Couto would be financing its investment through application for accessing European Development funds. The Structural Funds (SF) finance productive investment in Europe’s regions that would prove to be effective in meeting the objectives of the Union’s Cohesion policy, that is, contribute to the harmonious development of the Community by reducing to the minimum regional disparities and help to increase regional competitiveness. The SF can thus intervene in a wide spectrum of investments in relation to R&D that do not stop at physical infrastructure but can go up to support for businesses activities that link to R&D and Innovation.

Capital Structure Decision

The issue of capital structure has gained considerable attention from academicians, practitioners and policy makers alike due to its strategic impact on financing policy in particular and firm’s value in general.

The literature revisits two competing theories such as pecking order hypothesis and static trade of hypothesis and agency theory. Seminal work on The POH Model was tested by Myers and Majluf (1984). It was stated that it is the use of private information is the only recourse when managers seek to issue risky suggested securities when they are over-priced. Therefore, an outside investor will demand a higher rate of return on equity than on debt.

Myers (1984) had acknowledged of that the POH model does not explain why firms pay dividends. But when firms choose (for other reasons) to pay dividends, POH considerations should affect dividend decisions. Particularly because it is not desirable to finance investment with new risky securities which results in less attractive package in terms of dividends for firms with less profitable assets in place, large current and expected investments, and high leverage. Nevertheless if external finance is essential in view of the fact that internally generated funds are not sufficient to pay dividends and finance growth opportunities. The hypothesis propose that only firms which have low risk of financial distress will issue straight debt and the firms which have moderate risk of financial distress will issue hybrid securities (such as convertible debt or preference shares), despite the fact that those which have high risk of financial distress will issue external equity.

According to the hypothesis, firms only follow the hierarchical structure of chosen source of external finance described above. This is because of the amount of mispricing and loss of wealth to the shareholders where they depend on the type of security issued. The amount is least for debt and highest for external equity because the potential influence of new information on the value of a security, if the information is released to the market after the security is sold, based on the type of security. Such information will have the least impact on the value of debt because of the high priority of claims to the income and assets of a firm that is usually accorded owners of debt. But the information will have the highest impact on the value of equity because its owners usually have only a residual claim to the income and assets of a firm.

Pecking order hypothesis’s predictions about leverage, debt typically grows when investment exceeds retained earnings and falls when investment is less than retained earnings as opposed to a more complex view of the model. More recent study on pecking order hypothesis documented Fama and French (2002) have tested some qualitative predictions of the pecking order theory against the qualitative predictions of the tradeoff model. In their findings suggest that more profitable firms are less levered and it consistent with the pecking order. They also find out that the firms with greater investment opportunities are less levered as predicted by the tradeoff theory. But according Shyam- Sunder and Myers (1999), they are more focusing on the key quantitative predictions of the pecking order rather than focusing on the qualitative predictions. It is likely that the negative relation between leverage and expected investment predicted by the complex POH and the positive relation between leverage and investment of the simple POH may dominate.

Myers (1984) had advanced that in a POH world, firms do not have leverage targets. It had been advocated that considering future as well as current financing costs may lead to the desired targets which ca be soft. Firms with more expected investments may tend to have less leverage, but variables in time where net cash flows is concerned can be largely absorbed by debt.

The literature on static trade-off theory has been voluminous and a number of question has been asked as to whether or not expected increase tax-shield benefits from employing debt finance may offset the financial distress cost such as cash flow volatility, possible bankruptcy cost in the event of default, competitive threat if strained for cash. Based on this theory, optimum leverage is determined by balancing of the corporate tax saving advantage of debt against the deadweight costs of bankruptcy is intuitively appealing. This has been extensively discussed in DeAngelo and Masulis (1988), Bradley, Jarrell and Kim (1984), Barclay and Smith (1999) and Myers (2002). But, others have questioned it.

First of all, Miller (1977), Graham, J.R. and Harvey (2001), argue that the tax savings seem large and certain while the bankruptcy costs seems to be negligible, implying that many firms should be more highly levered than they are really are. Second, Myers (1984) argued that if this theory were key force, then the tax variables should provide an important insight about optimum capital structure decision. He found the tax effects seem to be fairly minor empirically. Third, Static-Order- Hypothesis theory predicts that more profitable firms should carry more debt since they have more profits that need to be protected from taxation. While other criticized this prediction such as Myers (1984), Titman and Wesels (1988) and Fama and French (2002). Higher profitability implies lower expected costs of financial distress and also the firms use more debt relative to book assets. Beside that, size as measured by assets, sales or firm age is an inverse proxy for volatility and for the costs of bankruptcy. The tradeoff theory predicts that larger and more mature firms use more debt.

Managers are agents of shareholders and their interests may be in conflict. Managers are said to favor perks, power and empire building even at the expense of shareholders. To control such behavior, debt is useful since debt must be repaid to avoid bankruptcy. Bankruptcy is costly for manager since International Research Journal of Finance and Economics - Issue 30 (2009) they may be displaced and thus lose their job benefits. The idea that debt mitigated agency conflicts between shareholders and managers can be found in many important studies including Jensen and Meckling (1976), Jensen (1986) and Hart and Moore (1988). There may also be agency conflicts between shareholders and debt-holders (Myers, 1977).

While thirdly important theory has been the agency theory. It is important to note the formation of capital structure does not necessarily control the agency cost. The agency cost of debt comprises of a problem of excessive dividends, issuance of senior ranking debt, asset substitution and underinvestment (Smith and Warner, 1979), which measure the possibility of bankruptcy and restructuring the debt and cost of monitoring debt covenant. The firm having higher debt financing will have increase likelihood of agency cost of debt. Generally manager being part of the owner tend to transfer wealth from bondholders to shareholders. In this circumstance the use of incentive contracts, such as options is more proper to mitigate this concern. It has been evidenced from that literature that more profitable firms should have more debt in order to control managerial behavior. Agency theory predicts that growth firm should have less debt. Firms that are expected to make profitable investments should have less need for discipline that debt provides. Regulated firms are likely to have fewer agency problems and so debt is less valuable as a control mechanism.

Generally there is no single listed firm that is entirely funded by either debt or equity because of the effect that the financial structure has the important implication on owner-manager behavior and creditor.

CONCLUSIONS

After estimating the relevant cash flows, the financial manager must apply appropriate decision techniques to assess whether the project creates value for shareholders. Net present value (NPV) and internal rate of return (IRR) are the generally preferred capital budgeting techniques. Both use the cost of capital as the required return needed to compensate shareholders for undertaking projects with the same risk as that of the firm. Both indicate whether a proposed investment creates or destroys shareholder value. NPV is the theoretically preferred approach, but IRR is preferred in practice because of its intuitive appeal.

Procedures for explicitly recognizing real options embedded in capital projects and procedures for selecting projects under capital rationing enable the financial manager to refine the capital budgeting process further. Not all capital budgeting projects have the same level of risk as the firm’s existing portfolio of projects. The financial manager must therefore adjust projects for differences in risk when evaluating their acceptability. Risk-adjusted discount rates (RADRs) provide a mechanism for adjusting the discount rate in a manner consistent with the risk–return preferences of market participants and thereby accepting only value-creating projects. These techniques should enable the financial manager to make capital budgeting decisions that are consistent with the firm’s goal of maximizing stock price.

References

Bradley, M., Jarrell, G.A. & Kim, E.H. 1984, “On the existence of an optimal capital structure:

Theory and evidence”, Journal of Finance, vol. 39, pp. 857–878.

Brealey A. R., C.S. Myers and, F. Allen (2008) Principles of Corporate Finance. 9th edition. McGraw-Hill.

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taxation”, Journal of Financial Economics, vol. 8

Fama, Eugene F. and Kenneth French, 2002, “Testing trade-off and pecking order Predictions

about dividends and debt”, Review of Financial Studies 15, 1-33.

Graham, J.R. and Harvey, C.R. (2001), “The Theory and Practice of Corporate Finance: Evidence from the Field.” Journal of Financial Economics, Vol. 61, pp. 1-28.

Hart, O. and J. Moore.,1988. “Incomplete Contracts and Renegotiation,” Econometrica, 56, pp.755-786.

Klammer, P.T., and M.C. Walker. (1984) The continuing increase in the use of sophisticated capital budgeting techniques. California Management Review, Vol.27(1), p. 137-148.

Michael C. Jensen, W. H. Meckling. 1976,”Theory Of The Firm: Governance, Residual Claims And Organizational Forms, Harvard University Press, December 2000, Journal of Financial Economics (JFE), Vol. 3, No. 4, 1976

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Myers, S.C. & Majluf, N.S. 1984, ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics, vol. 13, pp. 187–221.

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APPENDIX 1

TABLE 5 Major Types of Real Options

Option type Description

Abandonment option The option to abandon or terminate a project prior to the end of

its planned life. This option allows management to avoid or mini­mize losses on projects that turn bad. Explicitly recognizing the abandonment option when evaluating a project often increases its NPV.

Flexibility option The option to incorporate flexibility into the firm’s operations,

particularly production. It generally includes the opportunity to design the production process to accept multiple inputs, use flexi­ble production technology to create a variety of outputs by recon­figuring the same plant and equipment, and purchase and retain excess capacity in capital-intensive industries subject to wide swings in output demand and long lead time in building new capacity from scratch. Recognition of this option embedded in a capital expenditure should increase the NPV of the project.

Growth option The option to develop follow-on projects, expand markets, expand

or retool plants, and so on, that would not be possible without implementation of the project that is being evaluated. If a project being considered has the measurable potential to open new doors if successful, then recognition of the cash flows from such opportuni­ties should be included in the initial decision process. Growth opportunities embedded in a project often increase the NPV of the project in which they are embedded.

Timing option The option to determine when various actions with respect to a

given project are taken. This option recognizes the firm’s oppor­tunity to delay acceptance of a project for one or more periods, to accelerate or slow the process of implementing a project in response to new information, or to shut down a project tem­porarily in response to changing product market conditions or competition. As in the case of the other types of options, the explicit recognition of timing opportunities can improve the NPV of a project that fails to recognize this option in an investment decision.

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