MANAGERIAL DECISION-MAKING Essay

Abstract
The goal of the paper is to analyze a managerial decision related to generating addition business profit. Three investment opportunities are considered in the Definition section, and the issues which might affect the investment decision-making are considered in the Factors or Costs section. Using certain suggestions regarding the investment opportunities (described in the Measurement section), the investment opportunities are evaluated using such methods as payback period, net present value and internal rate of return. The implications of the analysis associated with the changes of factors involved in the decision-making are considered in the Summary section. The Conclusions and Recommendations section presents the analysis of the best decision and recommendations on the changes which might improve the learning process.

Executive Summary
Research question of this paper is: “What is the best long-term opportunity to invest the additional business profit: to place the savings into a fund, to invest into real estate or to support an agricultural project?”. The answer is – to support an agricultural project (option 3). The answer was determined on the basis of assumptions made in the Factors or Costs, and Measurement section. Financial methods of evaluating the investments such as NPV, IRR and payback period were used to analyze the effectiveness of three investment opportunities. Option 3 appeared to be the most effective since it generates increasing profits every year, yields a higher NPV and is less vulnerable to the changes of minimal return rate compared to other projects. This analysis can be highly useful for the investors willing to get maximal return on their savings during a given period (10 years, in the considered case). The choice between the opportunities is not obvious, and the analysis performed in this paper, as well as the consideration of implicit and explicit factors affecting the decision, are of great importance to potential investors.
Definition
The purpose of this paper is to analyze a quantitative managerial (economic) problem regarding investment issues. The research question is the following: What is the best long-term opportunity to invest the additional business profit: to place the savings into a fund, to invest into real estate or to support an agricultural project? The details of the investment options are the following:
the fund promises to give back a given percentage of the invested sum every year and after a given period of time, the initial investment will be returned to the company (conditions similar to bank deposit)
the savings can be invested to purchase houses or apartments, which can then be rented during the expected period of time; for the purpose of comparability of the investments, it is supposed that the apartments will be sold after a given period of time
it is possible to invest the savings into an agricultural project – apple orchard – which is not expected to generate any profit during first two years, but will then produce a linear increase in revenue during a given period of time. After this period of time, the orchard will have lower commercial value, and thus will be sold.
Introduction
Managerial decision-making often involves analysis of complex opportunities including both explicit and implicit costs. It is the manager’s responsibility to analyze all possible factors which might affect the situation at the current moment and in future, to determine the factors relevant to the problem and to quantify both explicit and implicit costs in order to determine the true economic costs of a financial or investment decision (Sexton, 2010). In general, explicit costs include all direct payments (where actual payment took place or will take place), and implicit costs represent the opportunity costs, i.e. the costs of alternatives which had to be given up instead of the current opportunity (Carbaugh, 2010).
In this paper, the analysis of investment decisions is performed with taking into account both explicit and implicit costs. First, the most important factors are chosen for constructing the financial model, which is further analyzed using three financial methods (NPV, IRR, payback period). Secondly, the sensitivity of the model to the changes of critical factors is considered. Finally, the recommendations for managerial decision-making are provided for the most probable situations and changes of the considered factors. The hypothesis is that the most profitable option will be Option 3, since it generates growing cash flows (although this project is associated with greater risks).
Factors or Costs
First of all, it is necessary to consider factors common for all three opportunities. One of the most important such factors is the length of the investment period (e.g. when the investor needs to get the money back and final profits are calculated). The next factor is the value of the sum of the savings; for different sums, different investment opportunities might be appropriate. Inflation rate should also be considered as the implicit factor affecting the investment decisions. The opportunity costs of investing these savings elsewhere or returning them to the business for the purpose of expansion have to be considered. Investment period and opportunity costs are implicit factors, while the amount of the savings to be invested is the explicit factor. Overall implicit costs can also be influenced by the cost of labor of the investor (the salary which could be earned by the investor if he or she chose to work for someone instead of pursuing own business opportunities) (Carbaugh, 2010). However, although this factor might seem to be important, it is not important for the considered question as the decision to invest is already made, and the opportunity costs of decisions other than investing the savings into one of three projects should not be considered.
Furthermore, it is necessary to consider implicit and explicit factors related to each of the three investment opportunities. For the first investment option (investing into a fund), such factors as the percentage of the invested sum annually paid back to the investor and the percentage of the sum which would be returned after the end of the investment period represent explicit factors directly affecting managerial decision-making. An implicit factor in this case is the risk that the fund would become a bankrupt and the investment revenues would be lost.
For the second opportunity (real estate purchase), the number of the real estate objects and their quality (as well as expected rent price) are the explicit factors directly depending on the amount of the savings invested into this opportunity. Other explicit factors are price of the apartment (or of the house), annual cash inflows generated by renting the apartments and residual value of the real estate objects. Factors which might be related to the investment decision are the renting risks (risks that the inflows from renting might change, fluctuations of the real estate prices and demand for real estate as well as risks of having periods when it would be not possible to find renters) and risks of related to natural disasters and other external factors which might destroy the apartments. The latter risks, however, can be covered by insurance payments, and thus can be considered as mitigated ones; hence, the consideration of these risks is not important for solving the investment question.
Finally, for the third opportunity explicit factors affecting the investment choice model are inflows generated by the apple orchard and the number of years required for the project to start generating a profit. The residual value of the orchard is also an explicit factor which should be included into the model. The risks associated with agriculture are higher and it is difficult to cover them with insurance payments: risks of bad harvest, changes in environment and natural disasters are additional factors associated with this opportunity. It is quite difficult to quantify these risks, so reasonable assumptions will be done in the next section of the paper.
Measurement
The length of the investment period is a factor which might depend on the needs of the investor, and can change in the course of time. In this analysis, investment period is selected as 10 years for all three opportunities, and it is supposed that the investor would not change the opinion in the middle of this period (e.g. that this period is fixed). Investment sum is evaluated as $500,000 (a reasonable sum of the business savings). This factor determines the possibility of using each of the investment opportunities, and thus might affect the available choices; the changes of this factor will be briefly considered in the Summary section.
It is quite difficult to measure the opportunity costs and risks since they involve a lot of fortuitous factors, and thus these factors will be classified as one factor – the minimal required rate of return acceptable to cover the associated risks and possible inflation rate. This rate is evaluated as 12% for the considered business. Possible fluctuations of this factors are also considered in the Summary section.
Other factors can be measured as follows: percentage of the invested sum annually paid back to the investor (fund option) – 10%, percentage of the sum which would be returned after the end of the investment period – 100% (the whole sum is commonly returned for such funds). Price of one apartment is evaluated as $250,000, and thus it is possible to purchase 2 apartments for the given amount of $500,000. It is expected that the apartments can be rented at annual price of $30,000 (all maintenance payments are already deducted from this amount). Residual value of each apartment after 10 years is expected to be $350,000. For the third investment opportunity, the number of years required for the project to start generating a profit is 2 years, cash inflows generated by the apple orchard are expected to be $60,000 at year 3 of the project, and are expected to increase by $30,000 every year until the end of the project. Residual value of the orchard is expected to be $80,000. Average risks associated with this project are already absorbed by the minimal return rate of 12%.
Analysis
For each of the options, it is reasonable to use net present value (NPV), internal return rate (IRR) and payback period (PB) since these are the main financial measures used to evaluate investment options (Gallagher & Andrew, 2007). These are three different methods for calculating the profitability of the investment, and each of these methods has own advantages and disadvantages. For all these methods, annual cash flows should be identified, starting from year 0 and ending in year 10. Payback period is the amount of time necessary to recover initial investment. If payback is negative or if this period is greater than maximal acceptable payback period, then the project should be rejected.
Net present value (NPV) is calculated as the sum of the present values of cash flows: , where is cash flow in period i, k is the discount rate, and n is the number of periods (Correia & Flynn & Uliana & Wormald 2007). The advantage of NPV compared to payback period is that this method can take into account not only the absolutely financial values, but also the time value of money. If NPV is positive, the project can be accepted; from the two projects with positive NPVs the one with greater NPV should be chosen (Drury 2005). Internal rate of return (IRR) is such a discount rate which turns the project’s NPV into zero (Drury 2005). If the project’s IRR exceeds the cost of capital, it is possible to accept the project.
Let us determine payback period, NPV and IRR for all three options. For option 1, cash flow for year 0 is -$500,000 (the investment itself), for years 1-9 cash flows are $50,000, and for year 10 cash flow is $50,000+$500,000=$550,000. Payback period for this option is 10 years (since only in the end of year 10 the amount of positive cash flows will cover $500,000).
Table 1 shows calculations of NPV and IRR. For NPV calculations, present value of every cash flow is determined as . For IRR calculations, Excel selection of parameter was used to determine the discount rate which results in zero NPV. Table 4 shows the appropriate calculations.
Payback period
10
IRR
0.10

Year
Cash flow
PV of cash flow
PV (IRR-based)

0
-$500,000.00
-$500,000.00
-$500,000.00

1
$50,000.00
$44,642.86
$45,454.55

2
$50,000.00
$39,859.69
$41,322.31

3
$50,000.00
$35,589.01
$37,565.74

4
$50,000.00
$31,775.90
$34,150.67

5
$50,000.00
$28,371.34
$31,046.07

6
$50,000.00
$25,331.56
$28,223.70

7
$50,000.00
$22,617.46
$25,657.91

8
$50,000.00
$20,194.16
$23,325.37

9
$50,000.00
$18,030.50
$21,204.88

10
$550,000.00
$177,085.28
$212,048.81

NPV
-$56,502.23
$0.00

Table 1. NPV, IRR and payback period for option 1
In this table, PV of cash flow = , PV (IRR-based) = . IRR value of 0.10 was determined using Excel parameter selection.
Thus, for option 1 NPV=-$56,502.23, and IRR=0.10. This option should be rejected basing both on NPV logic (NPV is negative) and on IRR logic (IRR is smaller than minimal rate of return).
For option 2, initial cash flow for year 0 is also -$500,000; for years 1-9 (end of the year is considered) cash flows constitute $60,000 ($30,000 for each apartment), and for year 10, cash flow is $60,000+$750,000=$810,000. Table 2 shows appropriate calculations.
Option 2
period (years)
10
annual rent
$30,000.00
repayment
$750,000.00
Payback period
9
IRR
0.145
Year
Cash flow
PV of cash flow
PV (IRR-based)
Payback sum

0
-$500,000.00
-$500,000.00
-$500,000.00
-$500,000.00

1
$60,000.00
$53,571.43
$52,392.20
-$440,000.00

2
$60,000.00
$47,831.63
$45,749.04
-$380,000.00

3
$60,000.00
$42,706.81
$39,948.21
-$320,000.00

4
$60,000.00
$38,131.08
$34,882.91
-$260,000.00

5
$60,000.00
$34,045.61
$30,459.87
-$200,000.00

6
$60,000.00
$30,397.87
$26,597.66
-$140,000.00

7
$60,000.00
$27,140.95
$23,225.16
-$80,000.00

8
$60,000.00
$24,232.99
$20,280.29
-$20,000.00

9
$60,000.00
$21,636.60
$17,708.82
$40,000.00

10
$810,000.00
$260,798.32
$208,755.84

NPV
$80,493.31
$0.00
Table 2. NPV, IRR and payback period for option 2
In this table, PV of cash flow = , PV (IRR-based) = . IRR value of 0.145 was determined using Excel parameter selection; Payback sum = Cash flow + previous Payback sum.
Payback period is 9 years, since $20,000 of investment not covered in year 8 will be paid in the end of the year 9. If rent payments are considered continuous, then payback period should be estimated as 8.33. However, suggesting that rent payments are done annually, payback period is estimated as 9 years. For this option, NPV=$80,493.31, and IRR=0.145 (14.5%). Since NPV is positive, and IRR exceeds the cost of capital, this option can be recommended for investing.
For option 3, cash flow for year 0 is -$500,000, for years 1 and 2 there are no cash flows, cash flow for year 3 is equal to $60,000, and starting from year 4, cash flows increase by $30,000 compared to the previous year. In year 10, cash flow will constitute $270,000 (apple sales) and $80,000 (sale of the orchard). It is not clear in the formulation of the option whether on year 10 the orchard still produces a commercial quantity of apples or not; in this calculation it is supposed that during year 10 orchard is still producing a commercial quantity of apples. Table 3 contains the appropriate calculations.

period (years)
10
first generation
$60,000.00
annual increase
$30,000.00
repayment
$80,000.00
Payback period
6.44
IRR
0.152
Year
Cash flow
PV of cash flow
PV (IRR-based)
Payback sum

0
-$500,000.00
-$500,000.00
-$500,000.00
-$500,000.00

1
$0.00
$0.00
$0.00
-$500,000.00

2
$0.00
$0.00
$0.00
-$500,000.00

3
$60,000.00
$42,706.81
$39,231.94
-$440,000.00

4
$90,000.00
$57,196.63
$51,077.21
-$350,000.00

5
$120,000.00
$68,091.22
$59,110.15
-$230,000.00

6
$150,000.00
$75,994.67
$64,131.03
-$80,000.00

7
$180,000.00
$81,422.86
$66,795.26
$100,000.00

8
$210,000.00
$84,815.48
$67,637.66
9
$240,000.00
$86,546.41
$67,092.92
10
$350,000.00
$112,690.63
$84,923.84
NPV
$109,464.71
$0.00
Table 3. NPV, IRR and payback period for option 3
In this table, PV of cash flow = , PV (IRR-based) = . IRR value of 0.152 was determined using Excel parameter selection; Payback sum = Cash flow + previous Payback sum.
For this option, payback period is 6.44 years (since during year 7 the orchard generates a cash flow of $180,000, it will cover the $80,000 of initial investment during $80,000/$180,000=0.44 part of the year). NPV=$109,464.71, and IRR=0.152 (15.2%). Regarding from the perspective of both NPV and IRR, the project is profitable and can also be accepted.
Basing on the initial minimal rate of return (12%) and on the NPV values, it is possible to determine that the best option is option 3, since it creates the largest NPV==$109,464.71. I have chosen NPV as the primary measure because it allows to distinguish between two projects and can be potentially adjusted to fluctuations of the discount rate.
Summary
The analysis of three chosen methods of investment evaluation showed that the most appropriate decision-making method for the considered case was NPV method. Project 3 (apple orchard) is the most effective opportunity according to NPV method. It should be noted that evaluation of NPV for option 3 also has certain limitations. First of all, calculation of NPV requires to focus on one discount rate (in this case, the minimal rate of return), and in real life during the 10-year period fluctuations of return rate are likely to take place. Secondly, NPV value does not take into account the costs of servicing the orchard (which might reduce expected cash flows). This is the general limitation of NPV – it supposed to determine exact values of cash flows, which might also be difficult in real life (Siddiqui, 2006). For example, in the case with the orchard, the annual increase of cash flows by $30,000 can be too optimistic, and might depend on a variety of non-financial factors. At the same time, NPV can be adjusted to the fluctuations of the rate of return, while IRR method would not work in these situations. Thus, NPV is still a preferred method of choosing the investment opportunity for the considered situation.
The changes of the factors determined in the Measurement section can result in certain changes of the decision. For example, if the risks were estimated lower and the minimal rate of return for the investment was set to 8%, all three projects would become acceptable, but project 3 would still remain the most profitable one. If the minimal rate of return increased to 16%, all three projects would become unprofitable, and it would be better to use alternative investment opportunities.
The changes of the invested sum would also change the investment solutions: if the invested sum decreased to $250,000, it would be only possible to purchase one apartment instead of 2, and it would not be possible to start the third project (which requires a minimum of $500,000 investment). In this situation, the option 2 (purchase of the apartment) should be preferred. In case if the sum of the savings increases to $1,000,000 and option 3 is scalable (it is possible to make the orchard larger), option 3 still remains attractive. However, if the invested sum doubled and option 3 was not scalable, then option 2 should be the choice, since it is more scalable and allows to gain more on the increase of the real estate prices. However, if all projects are equally scalable, option 3 should be preferred.
Conclusions and Recommendations
The analysis of three investment options – fund investment, purchase and renting of real estate objects, and agricultural project (apple orchard) – showed that taking into account all explicit and implicit factors affecting managerial decision-making and basing on the assumptions of the Measurement section, it is most effective to invest into the latter project. Overall, option 3 (apple orchard) is the most profitable project, since it yields the greatest NPV value and is less vulnerable to changes of the minimal return rate – it can remain profitable until the minimal return rate reaches 15.2%, while other projects become unprofitable at 12% and at 14.5% correspondingly.
The procedure of determining managerial decisions and identification of all associated costs was very important in the learning process and contributed to the understanding of real-life problems. However, it would be very useful to have examples of such analyses performed in real companies or by real individuals, and their perceived effectiveness. It would greatly add to the understanding of economic costs, and to the quality of assumptions made in the Measurement section. Also, having quantitative data on common risks and economic factors (e.g. inflation, bankruptcy, real estate price and rent fluctuations, etc.) would add to the quality of economic models.