HELSINKI UNIVERSITY OF TECHNOLOGY

Department of Engineering Physics and Mathematics

Systems Analysis Laboratory

Mat-2.108 Independent research projects in applied mathematics

CAPITAL BUDGETING IN A CAPITAL-INTENSIVE INDUSTRY

Tuomas Kuronen 55028E

Helsinki, 03 April 2007

1 INTRODUCTION ......................................................................................................3

2 CAPITAL BUDGETING...........................................................................................4

2.1 CHARACTERISTICS OF CAPITAL BUDGETING.........................................................4 2.2 METHODS OF CAPITAL BUDGETING ......................................................................5

2.2.1 Net present value ............................................................................................5 2.2.2 Internal and external rate of return................................................................7 2.2.3 Payback period...............................................................................................8 2.2.4 Value management tools ................................................................................9 2.2.5 Real options..................................................................................................10

2.3 DISCUSSION OF NPV AND IRR...........................................................................11 2.4 CAPITAL BUDGETING IN PRACTISE .....................................................................13

3 CAPITAL BUDGETING IN FOREST INDUSTRY.............................................14

3.1 DRIVING PRINCIPLES ..........................................................................................15 3.2 CHALLENGES .....................................................................................................15

4 DISCUSSION............................................................................................................16

4.1 ROBUST PORTFOLIO MODELLING ......................................................................17 4.2 REAL OPTIONS IN PAPERMAKING........................................................................19

4.2.1 Scenarios as supplementary material...........................................................21

5 REFERENCES .........................................................................................................21

5.1 LITERATURE ......................................................................................................21 5.2 INTERNET LINKS ................................................................................................22

1 Introduction

Capital budgeting is the process of allocating capital within a firm. This is done

to determine the long-term investments that secure the continuity and

profitability of the company. The process of capital budgeting is sometimes

referred to as investment appraisal1. By nature, capital budgeting is a process of

planning, and the implementation and monitoring activities are omitted from

this analysis. This planning process typically includes the use of a variety of

investment appraisal methods, which can be both quantitative and qualitative.

These methods may be divided into five; net present value, rate of return, ratio,

payback and accounting methods (Remer and Nieto 1995a, 1995b).

Capital-intensive industries, such as forest industry, hold some special

characteristics in their capital budgeting procedures. In Western paper

companies, the currently dominant production philosophy called 'multi-

product integrate', emphasises the economies of scale achieved by an

integrated paper mill (Ryti 1987). High amount of capital embedded in the

organisational structures and industrial infrastructure leads to capital-

intensiveness, and further to long payback periods and high gross capital

expenditure levels. This factor accentuates the importance of using proper

investment appraisal techniques, as the competitiveness of the company greatly

depends on the efficiencies thus achieved.

The purpose of this study is to explore literature on capital budgeting in large

corporations in capital-intensive industries. Subsequently, analysis of methods

that are widely incorporated in multinationals, how they are used and what

should possibly be taken into account in the future, is conducted.

After this introductory part, the fundamental methods, as well as practical

aspects of capital budgeting are presented and discussed in more detail. Next,

capital budgeting in forest industry is presented. The final section introduces a

heuristic model that seeks to capture the relevant issues in the industry.

1 In this study, the terms of 'capital budgeting' and 'investment appraisal' are used interchangeably, as in most cases in the literature.

2 Capital budgeting

Capital allocation problem typically consists of allocating a budget among a set

of competing investment possibilities. Here, investment appraisal is

distinguished from portfolio problems, following Luenberger (1998). However,

this distinction is reviewed in the discussion part of the study. Portfolio

approaches come into question especially in the case of interdependent

projects in which significant synergies can be achieved by choosing a particular

combination of projects. Here, an assumption of independent projects is

adopted, until otherwise noted.

2.1 Characteristics of capital budgeting

Projects that are budgeted through a firm-internal allocation process are

typically infrastructural assets, such as machinery, equipment or plants. Due to

their business specificity, there are typically no efficient markets for these

assets. In addition, projects assessed with investment appraisal methods require

discrete lumps of cash, as opposed to securities markets. In many cases, the

starting point is the constraining budget. Different investment candidates

compete of the same constraining budget, but nevertheless they contain

different characteristics in terms of scale, cash requirements and benefits that

their execution offers for the investing company. From a rational point of

view, all projects with positive outcome should be executed; due to the budget

limitation, this is rarely the case. This is why different investment appraisal

methods are used and assessed in normal capital allocation procedures. In

addition, optimisation can, at least intuitively, be seen as the method in

assessing capital allocation problems (Luenberger 1998).

In mathematical terms, the selection of a project can be formulated as a zero-

one optimisation problem. In the independent project setting, any combination

of projects chosen from the list of available projects is considered feasible.

Suppose m available projects and bi as the total benefit of the ith project. In

addition, ci denotes the initial cost of the project. C represents the total capital

available (budget). For each project, a zero-one variable xi is introduced, which

is zero if the project is rejected and one if accepted. Hence, the zero-one

problem is the following (Luenberger 1998):

(1)

In the zero-one model above, both the benefits and the costs are additive. The

benefits and costs can be assessed in many ways. The core selection process

shown above is there to provide the reader the mathematical expression of the

selection.

2.2 Methods of capital budgeting

In a setting of assumed project independence, the zero-one programming

problem is assessed with a variety of methods. Luenberger (1998) refers to the

use of benefit-cost ratio, NPV (benefit-cost) and profitability index

(NPV/cost) in these calculations. Due to the popularity of NPV and IRR

methods, these methods are discussed to begin with. The categorisation of

Remer and Nieto (1995a, 1995b) is followed here as well. Monte Carlo

simulation is also used in investment appraisal, as well as other probabilistic,

rather than deterministic approaches (Finch et al. 2002).

2.2.1 Net present value

The net present value method (NPV) is sometimes referred to as the net

present worth, or discounted cash flow model, but essentially, these

expressions mean the same thing. According to Akalu (2001), net present value

calculation is the following (corrected2):

(2)

If the nature of the project is such that it holds only the initial investment I0,

and it is made at the beginning of the investment period, the latter term will

simply be I0. In the Equation (2), NPV is the net present value, NCF the net

2 In Akalu's 2001 paper, the indices were faulty, and were accordingly corrected. Additionally, sum terms' indices were changed to start from 0.

( ) ( ).

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cash flow derived from the investment at period t, k being the cost of capital. T

is the life cycle of the investment.

The use of NPV starts from determining the discounting rate. It is also

referred to as minimum attractive rate of return (MARR) by Remer and Nieto

(1995a) and it describes the time value of money. In many cases, the rate of

return with which investment cash flows are discounted, is the weighted

average cost of capital3 (WACC) (Akalu 2001). WACC was developed by

Modigliani and Miller (1958) and is widely adopted. It represents the cost of

equity and debt embedded in the firm, and thereby determines the basis of the

return requirement of a modern company. Remer and Nieto (1995a) suggest

the process of implementing NPV in capital budgeting problem being the

following:

1. Determine the interest rate for the future cash flows

2. Estimate the economic useful life of the project

3. Estimate the cash flows of the project

4. Calculate the net cash flows

5. Calculate the present value (PV) of these net cash flows

If a project shows a positive outcome, it is accepted. However, in the case of

several investment alternatives showing positive NPV, the candidates may be

ranked according to their profitability index4 (PI) (Akalu 2001). On the other

hand, Luenberger (1998) suggests benefit-cost ratio in ranking projects.

Despite its popularity, DCF method has several shortcomings. To start with, it

ignores the size of the project (Remer and Nieto 1995a), which undervalues the

significance of the project in terms of its relative size. Moreover, NPV is not

considered suitable for so called 'soft projects', such as R&D and ICT-projects.

This has led to the adoption of mostly qualitative techniques in these cases,

such as methods based on intuition, experience and heuristics (Akalu 2003). In

fact, compared with real options approach, extensive use of basic DCF

techniques may lead to decisions that destroy value within the firm. Additional

weaknesses that are included in NPV are the lack of timely dimension

3 The calculation of weighted average cost of capital is rather straightforward: WACC = (after tax cost of debt) x (proportion of debt in the capital structure) + (cost of equity) x (proportion of equity in the capital structure) (Akalu 2001). 4 PI is the present value of NCF divided by initial investment (Akalu 2001).

(disregard of timing issues) and the presence of deterministic cash flow

assumption, which leads to short-termism. Moreover, NPV assumes same

levels of risk for both inbound and outbound cash flows (Akalu 2001).

2.2.2 Internal and external rate of return

Internal rate of return (IRR) is 'the rate that equates the cost and benefit of the

project in terms of present value' (Akalu 2001). More precisely, IRR signifies

the rate, at which the NPV of the project equals zero. This leads to the

deduction that IRR is the maximum cost of the financing of the investment. In

IRR, the word 'internal' effectively represents only internal factors and cash

flows, and no connection to 'external' factors is presented. These externalities

could be such as the MARR, or 'risk-free rate of return'. In conjunction with

the calculation of net present value shown above, IRR can be calculated as

follows5 (Akalu 2001):

(3)

The purpose of the method is to find the discount rate k, that is, IRR. It can

thus be interpreted as the percentage benefit from the given investment (Akalu

2001). Even though MARR or any other external factors are not incorporated

in the calculation, MARR is, however, used in assessing the profitability of the

project. If the calculated internal rate of return is greater than the return

requirement, the project is accepted. If IRR and MARR are equal, the investor

remains indifferent. Finally, if IRR is less than the market-rate of money, the

project proposal is rejected (Remer and Nieto 1995a). Respectively, when

considering a 'hard' budget constraint in capital budgeting situations, MARR is

used in ranking the selection of investment proposals. Within a company that

operates in a free market system and is possibly listed, comparing the IRR of a

project with the firm-internal cost of capital might show enlightening results.

Despite its popularity (Remer and Nieto 1995a), the IRR method has several

drawbacks. First, it assumes the reinvestment of revenues with IRR (Remer

and Nieto 1995a; Luenberger 1998). Second, it gives ambiguous roots when

5 The formula is modified from Akalu (2001) with slight corrections and indices set to start from 0.

( ) ( ).0

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sign reversal occurs more than once in the cash flows deriving from the project

(Remer and Nieto 1995a; Luenberger 1998; Akalu 2001). Third, it assumes the

same rate for lending and borrowing. Finally, it assumes equal cost of capital

for each year of discounting, which is contrary to the practical world and

(Akalu 2001).

Considering these drawbacks, adding a certain degree of externality to the

picture could provide promising results. External rate of return (ERR) does

not assume that all cash flows are reinvested at IRR, but rather at another rate.

This 'external' rate is in some cases set to equal MARR, but other rates might

be used as well. By assuming the reinvestment rate of MARR, the use of ERR

would enable the company to bring helpful externalities into discussion and

thereby rank projects giving more certainty to the assessment, since it

determines the minimum guaranteed return of the project (Remer and Nieto

1995a). Considering the reinvestment rate, other possibilities could be using

WACC or realised average internal rate of return from company's internal

projects, instead of assumptions.

2.2.3 Payback period

The payback period method (PBP) accumulates the annual return of an

investment until the cumulative cash flow coming from the project equals the

cost (negative cash flow) of the investment. The time consumed in achieving

this is called the payback period (PBP), calculated as follows (Akalu 2001):

(4)

In the formula, I is the amount of investment and Π is the annual profit in

annuity form. Hence, the method shows how quickly the cost of an investment

is recovered, but does not regard the profitability of the investment in any way.

Considering the requirements posed by management, the realised payback

periods vary to some degree, normally deviating somewhere between two and

four years. There is some deviation, however, especially in terms of the nature

of the project; new technology projects tend to pay themselves 'back' in a

slightly longer period than conventional ones (Lefley 1996).

.

Π=

IPBP

The use of PBP is found to be positively related to capital budget size. One

might speculate, is it due to the importance of securing a proper payback of the

capital allocated. On the other hand, however, the importance of PBP is found

to be inversely related to capital budget size. With great amounts of capital, a

wide variety of investment appraisal methods is used. Finally, PBP and firm

size show conflicting or no results in terms of mutual connectedness in the

literature. In general, PBP is used in projects that are less strategic by nature

(Lefley 1996).

Despite its popularity in the past, the use of PBP has been declining from the

1970s to the 1990s. Moreover, very few of the companies using the payback

method use it as the sole project evaluation criterion (Remer and Nieto 1995a,

1995b). This may be due to the increased awareness of the drawbacks and

limitations of the payback method. First, it has no regard for cash flows after

the payback has taken place (Remer and Nieto 1995b; Lefley 1996). The cash

flows that emerge after the payback are, however, the same ones that

determine the rate of return of the investment. Additional drawback held by

PBP is the fact that it ignores the timing of the returns completely. On the

other hand, one of the advantages of the payback method is that it sometimes

provides a quick way of determining the risk of a project. However, customary

users of payback method and its variants should possibly regard it as a

supplementary investment appraisal method, to be used in conjunction with

other, more sophisticated methods that consider the time value of money

(TVM).

2.2.4 Value management tools6

Economic value added (EVA) gives an estimate of 'true' economic profit after

making corrections to accounting, including deducting the opportunity cost of

equity capital. According to Wikipedia, EVA's current theory is formulated by

Bennett Stewart and Joel Stern. EVA tells the additional value created for the

shareholders of the firm after the required return. The calculation is

straightforward:

6 According to Akalu (2003), value management tools is a group of techniques 'that provides unambiguous metric-value upon which an entire organization is built. It emphasizes on cash flows oppose to accounting profit. Models in this group includes such as SVA and EVA.'

(5)

In Equation (5), r is the return on capital employed (ROCE), c is the required

return on capital – in other words – the weighted average cost of capital

(WACC) and K is the capital employed. Critics note, however that EVA is

incapable of measuring the shareholder value creation in a company. In a

geographical context, EVA is used in conjunction with DCF methods in UK

(Akalu 2003).

2.2.5 Real options

In some cases, the word option is associated with investment opportunities in

the sense of investment appraisal, rather than financial securities. For instance,

the opportunity of investing in industrial infrastructure may be seen as a

possibility, but not an obligation to the management. The word real comes into

discussion because the fact that in this context, the potential investments

concern real activities or real commodities (non-financial), as opposed to the

case of financial instruments. As in the case of capital budgeting problems in

general, real options are not tradeable. The expression real options can also be

used to describe the way of thinking, in which derivative analysis may be used

in approaching real world investment problems as well (Luenberger 1998).

The real options approach embraces the concept of uncertainty. There must be

uncertainty in terms of future cash flows deriving from the investment, and

management must have flexibility to assess this uncertainty as it evolves

(Gilbert 2004). As uncertainty is in the core of this approach, investments that

can be described as 'cash cow' –investments, are well analysed with existing

(DCF-based) techniques. As dominantly a way of thinking, real options have a

set of feasible applications (Amram and Kulatilaka 1999):

• When there is a contingent investment decision. No other approach

can correctly value this type of opportunity.

• When uncertainty is large enough that it is sensible to wait for more

information, avoiding regret for irreversible investments.

• When the value seems to be captured in possibilities for future

growth options rather than current cash flow.

( ) .KcrEVA ⋅−=

• When uncertainty is large enough to make flexibility a consideration.

Only the real options approach can correctly value investments in

flexibility.

• When there will be project updates and mid-course strategy

corrections.

Real options approach could prove to be beneficial in considering shut-downs

and other forms of disinvesting. In fact, these actions are also forms of

investment (Dixit and Pindyck 1995); money-losing operations have a cost, and

assessing these problems with real options approach might prove to be fruitful.

Rather than focusing on the costs, identifying the trade-offs and alternative

costs might pave the way for the wider understanding of the financial

consequences of shut-downs.

Real options approach holds some drawbacks as well; it is complex, it demands

significant computational work and additional data (Akalu 2003). Moreover,

communicating real options approach and its findings in a real-life situation

within a company might prove to be challenging, simply because of the general

lack of expertise in options theory.

2.3 Discussion of NPV and IRR

Despite the emergence of new methods, the traditional ones, NPV and IRR

are still the most popular (Remer and Nieto 1995a). However, it can be argued

that a shift from IRR methods towards the NPV methods has occurred from

the 1970s to 1990s. Simultaneously, the popularity of payback methods has

diminished (Remer and Nieto 1995a). Nevertheless, the following section is

devoted to IRR and NPV and the discussion of their special characteristics and

possible connections between the two.

As many scholars agree, NPV is simple to calculate (Dixit and Pindyck 1995;

Remer and Nieto 1995a; Luenberger 1998). Additionally, it holds no risk of

ambiguous roots, as is in the case of IRR. On the other hand, IRR depends

only on the properties of the cash flow stream, having nothing to do with the

prevailing discount rate, which is sometimes troublesome to calculate.

Considering these factors, it seems that both methods have their place in

investment appraisal, but in different situations (Luenberger 1998).

IRR can be used when the investment can be repeatedly reinvested in the same

type of project, with the sole exception that it can be scaled in size. This is how

the maximum growth of is capital achieved. One should bear in mind,

however, that investment situations are rarely identical, which puts serious

pressure to the selection of IRR criterion. Respectively, NPV's strengths lie in

'one-timers', since it compares the investment with the rate of return of normal

financing channels, and thus creates a healthier situation of comparison in

contemplating the feasibility of the investment. Even though determining the

discounting rate might not be easy, the time value of money should be

considered every time if possible. In business situations, the most feasible

baseline for comparison would perhaps be the cost of capital (WACC) to

which all investment proposals in the company would be compared. The cost

of capital is an important factor in identifying the efficiency requirement of the

capital usage of the owners of the company.

Often, IRR is considered as the criterion of the investor (maximum return),

NPV being the method of the owner (maximum value). Hence, both methods

are needed to understand the assessment of capital budgeting problems. To

alleviate the conflict between the two methods, the harmony theorem is

introduced. It states that there is harmony between the two criteria, when

ownership is considered. To summarise, the harmony theorem functions as a

justification for operating a venture in a way that maximises the present value

of the cash flows it generates. In this way, both the investors and owners will

agree on the policy (Luenberger 1998).

It can be argued, however, that both these methods are incapable of capturing

the shareholder value created by the investment and thus unsuitable for capital

budgeting purposes. Moreover, studies have failed to show positive correlation

between the DCF method and firm profitability. First, DCF ignores the

preparatory stages of the investment; it leads to the rejection of strategic

investments. Second, the use of DCF methods in the appraisal stage of the

project and non-DCF methods in evaluating the realised performance, lead to

the disconformity of the results. Third, when assessing an individual project,

the question of indirect and direct costs may become problematic. NPV and

IRR favour investment proposals with high indirect and low direct costs. This

problem is twofold; it favours projects from unprofitable parts of the business

and simultaneously contradicts the conventional management thinking that it is

better to have high direct and low indirect costs, in terms of controllability

(Akalu 2001).

Fourth, neither NPV nor IRR consider debt usage in financing the investment

in any way. Fifth, the principle of investing 'now or never' does not take lost

opportunities into account. Sixth, neither of these methods assesses the

possibility and consequences of the changes that (most likely) will occur in the

appraisal framework and business environment. Consequently, uncertainty

increases. Some additional faulty assumptions embedded in these methods

exist, and they are presented in the literature (Akalu 2001). Considering the

weak points of the methods, especially in the case of problems number five

and six, real options approach might prove to be useful. Harmful and value-

destroying mental models, as well as the inability to imagine non-linear

outcomes of strategic actions could possibly be tackled using options approach

in investment appraisal.

2.4 Capital budgeting in practise

The most widely used methods in capital budgeting and project selection are

net present value, internal and external rate of return, return on investment7,

benefit/cost ratio8 method and payback period methods. As previously noted,

a shift from IRR to NPV methods has taken place during the last decades

(Remer and Nieto 1995a).

Evidence from 10 large British and Dutch companies shows that high

performing companies use market-based methods, frequent assessment &

monitoring, as well as value-based management and modified DCF methods

(Akalu 2003). Especially in the case of so called 'soft projects', such as R&D

and ICT projects, qualitative methods are widely used. Respectively, low

performing companies use accounting-based methods, infrequent assessment

7 Return on investment (ROI) is not discussed in this paper due to its imminent shortage – it does not consider the time value of money. Because of the ignorance considering the (TVM), it gives misleading results (Remer and Nieto 1995b). 8 The scope of this study is in the quantitative methods of investment appraisal. As monetary values are difficult to attach to benefit/cost ratio, especially in terms of benefits, this method is omitted from this discussion. Additionally, the results it shows are in many cases aligned with the results shown by the net present value method (Remer and Nieto 1995b).

and monitoring, accounting and basic DCF-based models, as well as mostly

qualitative methods. This study strongly suggests adding more complexity to

the models currently in use. One step into this direction would possibly be the

adoption of simulation, real options and portfolio techniques.

3 Capital budgeting in forest industry

Forest industry and more precisely, papermaking, can be seen as an exemplar

of capital-intensiveness. For decades, the capacity of new paper machines has

been growing. The reasons for this are intricate; dominant production

philosophy searching efficiencies of scale, cluster-effects, and so on. Regardless

of the reason(s), forest industry companies, especially in the Western

economies are in a situation in which their profitability and therefore whole

existence is threatened due to serious overcapacity and erosion of profitability.

In forest industry (as in other industries as well), the bulk of capital budgeting

methods are based on conventional DCF techniques. IRR-based methods are

also notably popular in the industry, increasing their popularity since the 1970s,

despite the pressure in the relevant literature against them. In addition, some

larger companies use more sophisticated evaluation methods, such as

economic value analysis. In general, quantitative analysis methods are rated

higher nowadays than in the 1970s (Hogaboam and Shook 2004).

However, there are still several obscurities remaining in the industry, especially

considering the concept of 'risk'. This concept is dominantly considered in a

subjective, non-theoretical manner, rather than referring to the concept of risk

suggested by the literature. In fact, the companies showed more subjectivity

towards risk analysis than in the past. The use of mathematically more

sophisticated methods, such as covariance analysis, simulation studies or

decision-tree analysis is found to be at most marginal (Hogaboam and Shook

2004).

As the business environment in forest products industry can be considered

very competitive, assessing capital allocation problems using the most elegant

techniques would be justifiable. However, despite the progress during the 17

years between survey studies (Hogaboam and Shook 2004), there are still

serious shortcomings in the practise of investment appraisal. For instance, IRR

is still used with mutually exclusive project even though literature shows that

NPV better suits this kind of problems.

3.1 Driving principles

Forest industry consists of sub-industries that hold different characteristics. It

may be considered to represent a set of relatively mature, large-scale industries

that have globalised quite recently (Ojala et al. 2006). It can be argued that in

the past, the main driver of investment was not the effective management of

capital, but rather the need to create capacity in order to fulfil the market

demand for the end-products, that is, paper. Nevertheless, the former set of

incentives that were mainly motivated by unsatisfied, growing markets, has to

be replaced with a new one, in order for the industry to survive. This applies

especially to Western forest industry companies, as they face increasing

competition from new players, many of which are from the 'new Asia'.

When capital budgeting methods in the forest industry are considered, IRR is

among the most popular methods in use. Sometimes choosing this method is

explained through referring to the difficulty of determining a 'risk-adjusted'

discount rate in using NPV. One question still remains unanswered: why is

MARR suitable for comparing the internal rates of the project proposals with

the market return, but not in the case of net present value calculation? On the

other hand, choosing projects according to their IRR-order, until the budget

constraint is met, is not optimal. It increases the risk of leaving a part of the

budget intact.

3.2 Challenges

Considering capital budgeting, one question is of special importance in

papermaking context: the 'hardness' of the budget constraint. This is taken into

discussion because of the need of understanding the importance of adapting to

the present situation. Hard budget constraints are problematic. An inflexible

threshold value for the capital spending puts significant pressure on the

selection of the investment appraisal method. Poor choice of method or a

combination of methods leads to the selection of a weak project with greater

probability than in the case of choosing a good one. Consequently, a hard

budget constraint increases the absoluteness of the method; let it be good or

bad. The 'softness' of budget constraints can be divided into two. On one

hand, it may be beneficial for the company to have a 'soft' or 'flexible' budget

constraint (profitable projects are executed). On the other hand, soft

constraints may significantly increase the methodological complexity in

assessing investment appraisal problems.

In the literature it has been reputed that sophisticated capital budgeting

methods are either not in use, or they are in use at most to a limited degree

(Remer and Nieto 1995a, 1995b; Akalu 2003; Hogaboam and Shook 2004).

Simultaneously, many scholars agree that globalising world is increasing

competitiveness, which for its part increases uncertainty in the business

environment. In addition, the competitive situation is already tough, and no

lucrative, easy-to-exploit market areas are likely to emerge. The new capacity

that is being built appears mostly in Chinese mainland.

In a capital-intensive industry setting, life cycle problems are of special interest.

First, life-cycle-based investment appraisal methods could be explored more

thoroughly in terms of usability. Second, a major issue in the industry is

presently the fact that life cycle problems are in different hands than day-to-day

operations. This may lead to the myopia in terms of understanding the relative

versus absolute utility dilemma that is present in papermaking nowadays.

Moreover, as 'paper integrate thinking' continues as the dominant mindset in

the industry, some calculations remain undone. Applying such thinking in

calculations that challenge the dominant mental model, could provide

surprisingly fruitful results. An example of this could be, for instance, a fixed

versus variable cost calculation, in which relative versus absolute utility would

be mapped to understand the underlying dynamisms of the industry more

thoroughly.

4 Discussion

In the beginning of this paper, projects were assumed to be independent. In

reality, however, significant synergies can be achieved, if only project-to-project

synergies can be identified (when they exist). This is the reason why various

portfolio approaches should be taken into account. In addition, there have

been some attempts to use capital asset pricing model (CAPM) also in capital

budgeting problems, instead of just securities market. For some reason,

however, it has not become common.

4.1 Robust Portfolio Modelling

Robust Portfolio Modelling (RPM) (Liesiö et al. 2006) could prove to be

helpful when applied to capital allocation problems. RPM 'is a decision support

methodology for analysing large-scale multiple criteria project portfolio

problems'9.

The RPM methodology extends the use of preference programming into

portfolio problems where a subset of available project candidates is to be

financed considering multiple criteria. Additive scoring model is used to model

the overall value of each project in a setting of incomplete information. That is,

weight coefficients are not be fixed as precise values, but rather as intervals.

Ultimately, RPM builds on the computation of efficient portfolios. A portfolio is

efficient (non-dominated), if it is not possible (using existing assets) to

compose another portfolio, the overall value of which is higher considering the

allowed weights and values. The process of RPM is shown in Figure 1 (Liesiö

et al. 2006).

9 As noted in the RPM-page of Systems Analysis Laboratory: http://www.rpm.tkk.fi/

The definition of a 'core project' is the following (Liesiö et al. 2006):

'If the core index of a project is 1, the project is included in all non-dominated

portfolios; it is consequently called a core project. At the other extreme, if its core index

is 0, the project is not included in any non-dominated portfolio; it is therefore referred

to as an exterior project. Finally, projects whose core index is strictly greater than zero

but less than one are called borderline projects'.

Mathematically, core, borderline and exterior projects are defined as follows

(Liesiö et al. 2006):

(6)

The core projects would be chosen in the portfolio that maximises the overall

portfolio value in a situation of additional information concerning the point

estimates of weights and score parameters (Liesiö et al. 2006).

Figure 1 Robust Portfolio Modelling (source: http://www.rpm.tkk.fi/)

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4.2 Real options in papermaking

'Real options in papermaking' could be the topic of a research paper, thesis, or

a dissertation in exploring the possibilities that option pricing approach offers.

Especially considering the non-linearities, the cost of waiting and hedging, real

options could provide valuable information in terms of capital budgeting.

Contemplating either new investments or shut-downs (disinvestments) in the

new market situation, the need of applying novel approaches in the forest

industry setting is imminent. Increased market volatility, the grown probability

of technological discontinuity and/or industry shakedown, as well as the role

of strategic investments in this context, suggest that a significant source of

advantage could reside in 'new investment appraisal methods'.

One possibility could be combining RPM and real options approaches. This

would take place in the following manner. First, RPM would be used to

identify the core and exterior project candidates. Core projects form the basis

of the portfolio, as they are included in all efficient (non-dominated) portfolios.

Instead of using RPM methodology in identifying the core projects, other ways

could be considered as well. Considering the historical practises in investment

appraisal that are being used in firms, it might prove beneficial to use the

traditional capital budgeting methods in conjunction with RPM. Hence, NPV

and IRR could be used to identify the core project proposals, thereby paving

the way for novel approaches, yet adhering to accustomed practises.

Consequently, the decision maker(s) would have three sets of projects: core,

borderline and exterior. Core projects would be executed in any case, but the

novelty of this approach lies in the handling of the borderline. The suggested

framework is shown in Figure 2. In the figure, on the horizontal axis is the

lifetime of an investment. On the vertical axis, respectively, are the (real)

options available for the company.

Figure 2 Real options in papermaking

The figure should be interpreted so that interdependent investment proposals

can be modelled mathematically. For instance, investment A could represent

'the procurement of land from the Southern hemisphere'. Consequently,

investment B could be 'the start of planting activities', and C 'waiting'. In this

case, the investor(s) would have the possibility to allocate uncertainties to the

respective investment possibilities. Additionally, what is notable here is that

investments such as 'waiting', 'shut-down' etc. are considered as investments, as

the 'building' investments. In mathematical terms the setting is the following:

(7)

This is interpreted so that B and C are only executable in case of the realisation

of the project A. In addition, both of the two options B and C can be either

done or not (using the option or not). Considering the 'real-life' example of

land procurement in the Southern hemisphere, starting planting activities or

waiting, is an example of real-world options. Identifying investment

possibilities using real options is presented here to develop the option-based

thinking in capital budgeting. In this model, there is still plenty of room for

traditional thinking, in terms of choosing the core set of projects. Nevertheless,

Time (a)

Options

5 10

A

B

C

etc.

DM situation NPV, IRR, etc.

.1≤+

≤

≤

CB

AC

AB

a novel approach for assessing investment candidates with higher uncertainty

levels is presented here.

4.2.1 Scenarios as supplementary material

Foresight methods, such as scenario analysis could provide additional insights

in mapping future events (Lehtinen 2006). Identifying the relevant parameters

to which the central factors, such as profitability are sensitive, would function

as the basis of scenario-added analysis. These scenarios would serve as

supplementary material in pondering the right choices in the borderline. In

addition, considering 'invest-or-wait'-situations and real options, scenarios

could bring pivotal views to decision making: 'is it reasonable to invest now,

wait, or discard the project?' Naturally, fitting the two methods together would

require the definition of 'a universal language' in terms of communicative

parameters. In any case, novel approaches are needed, and the suggestions

presented here are a mere proposal into that direction.

5 References

5.1 Literature

Akalu M. (2001), 'Re-examining project appraisal and control: developing a

focus on wealth creation', International Journal of Project Management, 19: 375-383.

Akalu M. (2003), 'The process of investment appraisal: the experience of 10

large British and Dutch companies', International Journal of Project Management, 21:

355-362.

Amram M. and N. Kulatilaka (1999), Real Options: Managing Strategic Investment in

an Uncertain World. Harvard Business School Press, Boston.

Dixit A. and R. Pindyck (1995), 'The options approach to capital investment',

Harvard Business Review, May-June.

Finch J., F. Macmillan and G. Simpson (2002), 'On the diffusion of

probabilistic investment appraisal and decision-making procedures in the UK's

upstream oil and gas industry', Research Policy, 31: 969-988.

Gilbert E. (2004), 'Investment Basics XLIX. An introduction to real options',

Investment Analysis Journal, 60: 49-52.

Hogaboam L. and S. Shook (2004), 'Capital budgeting practices in the U.S.

forest products industry: A reappraisal', Forest Products Journal, 54: 149-158.

Lefley F. (1996), 'The payback method of investment appraisal: A review and

synthesis', International Journal of Production Economics, 44: 207-224.

Lehtinen H. (2006), Construction of demand scenarios in paper industry. Helsinki

University of Technology, Espoo.

Liesiö J., P. Mild and A. Salo (2006), 'Preference programming for robust

portfolio modeling and project selection', European Journal of Operational Research,

in press.

Luenberger D. (1998), Investment Science. Oxford University Press, New York.

Modigliani F. and M. Miller (1958), 'The cost of capital, corporation finance

and the theory of investment', The American Economic Review, 48: 261-297.

Ojala J., J.-A. Lamberg, A. Ahola and A. Melander (2006), 'The Ephemera of

Success', The Evolution of Competitive Strategies in Global Forestry Industries:

Comparative Perspectives, J.-A. Lamberg, J. Näsi, J. Ojala and P. Sajasalo (editors).

Springer, Dordrecht.

Remer D. and A. Nieto (1995a), 'A compendium and comparison of 25 project

evaluation techniques. Part 1: Net present value and rate of return methods',

International Journal of Production Economics, 42: 79-96.

Remer D. and A. Nieto (1995b), 'A compendium and comparison of 25 project

evaluation techniques. Part 2: Ratio, payback, and accounting methods',

International Journal of Production Economics, 42: 101-129.

Ryti N. (1987), Puunjalostustalous. Otakustantamo, Espoo.

5.2 Internet Links

http://en.wikipedia.org/wiki/Economic_value_added

http://www.rpm.tkk.fi/