Hagan Summer Symposium
Corporate finance assumes contingencies. Why? Finance estimates values to mirror the uncertainty of events, and thus, “involves assumptions,” about future risks because past events may not representatively reflect future events. [i]
To infer the past representatively reflects future events neglects, as an unwarranted assumption, possible change evinced throughout history. In reality, future values regularly fail to comport with initial projections. Hence, finance estimates on the assumption of uncertain valuation manifested in future events because conditions—and by extension future values—tend to change. Therefore, corporate finance assumes contingencies to consider the probative event of plausible change.
Among those contingencies involve determining whether discounted estimates of expected future cash flows from Net Present Value (NPV) calculations exceed initial investment and other expense. Accordingly, a cost-benefit analysis demonstrates significance in ascertaining if return on investment (benefits) surpass costs such that rewards justify investment (costs).
Why? If costs exceed rewards, the cost-benefit analysis most strongly supports disposing a project due to its unprofitability, specifically, insufficient return on investment. For example, weighted average cost of capital (WACC) assumes a cost-benefit analysis, guiding firms when (or when not) to invest in risky projects. WACC may dissuade firms and/or investors from imprudent risks if discounted projections imply a project incurs countervailing costs. Alternatively, WACC may reveal how sometimes, initial investment, up-front costs, may economize budgeting in the long-run.
On Saturday, July 30, 2016, Iona College featured its Hagan-CIBER Summer Symposium: Global Economy and Politics of Energy. The symposium showcased scholars, several of whom incorporated a cost-benefit financial analysis to substantiate its significance for firms in achieving economic viability from long-term investment. This essay, in pertinent part, shall highlight some of the relevant Corporate Finance cost-benefit analysis themes presented, beginning sequentially with Dr. Rowland.
Cost Benefit Analysis—Passive House:
Finance generally assumes inaccurate calculations due, inter alia, to market uncertainty. A cost-benefit analysis reflects this principle. Indeed, a cost-benefit analysis might assume different financial analysis applications/measurement methods employed as evidenced in value differentials from the same subjects studies. Marty Rowland, Ph.D., Professional Engineer, in his presentation, Passive House Design: Success Record and Cost Differentials, instantiates this instance. For example, according to Dr. Rowland, Tim McDonald, architect and colleague who presumably “pioneered” passive house design, conducted a cost-differential analysis with over 100 projects. The research compared construction costs vis-à-vis passive house versus standard design. His comparison elucidated the following:
- Single Family Standard: $147/sf PH: $130/sf
- Multi-Story Standard: $158/sf PH: $151/sf [ii]
Assuming the accuracy of these values, passive house design distils cost reductions—respectively $17, single family, and $7, multi-story—from standard models in each category. If accurate, the passive houses for both categories respectively reference an approximately 11.6%, single family, and nearly 4.4% cost reductions compared to standard models. Again, assuming arguendo no mathematical mistakes (excluding rounding errors), the arithmetic average equates to almost 8% or roughly 7.9% for a geometric average. Yet, Gologic.com estimates the cost-reduction differential at presumably 7%. [iii] If true, these analyses show an approximate 1% differential. Though arguably a statistically insignificant differential, the evidence elicits questions as to whether differences reasonably stem from different cost-benefit financial analysis applications.
To strengthen the conclusion this differential might stem from different financial applications, Dr. Rowland in subsequent correspondence generously provided a confidential construction cost summary. He permitted me to reference the summary without reproducing it. Dr. Rowland described the differentials pursuant to Tim McDonald’s clarification. The summary juxtaposed a similar comparison, however, this time, involving 85 projects, comprising 32 Passive House (PH) projects and 53 non-Passive House (non-PH) projects. [iv] The summary showed $169 average costs for PH projects and $165 average costs on non-PH projects. [v] If true, assuming no mistakes, the evidence purports a nearly 2.37% cost differential—0.623% weighted cost differential. [vi] Despite this differential, if accurate, the study here, unlike earlier, presents non-PH projects as presumably cheaper than PH projects. Therefore, assuming no arithmetical errors, this inverted differential might factor into Gologic.com’s lower 7% cost differential, depending on the financial applications deployed for its measurements. Ultimately, ceteris paribus, these statistics reinforce the probative inference of different financial analysis applications/measurement methods plausibly influencing cost differentials.
Cost-Benefit Analysis—Investment Value of Research & Development
Professor Jai Seong Kang’s Operating Risk & Return in Fixed Cost Spending demonstrated how initial investment might mitigate long-term costs for economic viability. His presentation demonstrated how firms may maximize reward while simultaneously mitigating risk in achieving a break-even point market-equilibrium. In Finance, this break-even point for firms at a microeconomic level represents the return on investment. Professor Kang illustrates this concept in a cost-benefit analysis. For example, Kang’s analysis compares the initial investment strategies of two pharmaceutical firms—S & E. S Company omits Research & Development (R&D). E Company invests in R&D. [vii] Apparently, E Company showed higher risk from higher Operating Leverage attributed to higher fixed costs than S Company. [viii] But S Company incurred both fixed and variable costs, with total costs presumably exceeding E Company. If accurate, this study shows the investment value of R&D overshadows higher costs associated with omitting it because S Company’s costs evidently superseded E Company. Hence, if true, the study validates:
- Finance theory of greater reward assumed for higher efficient risk;
- Common sense—that R&D typically lowers long-run costs, and thus heightens return on investment, because it provides an opportunity to discover defects. An opportunity to discover defects increases the probability of mitigating non-conformance risks—which if triggered, plausibly portends insolvency from government recalls, lawsuits, and/or reduced financing.
Therefore, the cost-benefit analysis affirmed benefits surpassing costs for R&D because diminished long-run costs associated with it tends to appreciate return on investment.
Unviable Infrastructural Plans Hosting Olympics
Iona Professor Dr. Donald Grunewald in Power, Politics, Protocol of the
International Olympic Committee: An Organization Theory Case Study discussed economic viability implications for foreign governments presumably failing to plan infrastructural resources while hosting Olympic events. According to Grunewald, some governments optimistically overestimate financial capacity and/or underestimate financing for fundamental facilities while hosting Olympic events. For example, Brazil constructed a brand new Olympic building without any toilet facilities. [ix]
This issue proves pertinent in Corporate Finance which emphasizes the significance of sensitivity/scenario analysis methods—considering pessimistic and realistic situations to avert overly optimistic predictions. [x] Best-case scenarios neglect plausible outcomes. Why? The best case scenario assigns undue weight to favorable circumstances unmitigated by realistic and/or pessimistic considerations. The failure to conservatively consider plausible outcomes in calculations creates an almost surefire recipe for disaster because it assumes fantastic forecasts inconsistent with reality. The Brazil example suggests a best-case scenario. Brazil presumably believed they possessed adequate resources for a new facility, neglecting the cultural implications of outsider expectations in their projections. They appropriated just enough funding for the project within their limited budgeting capacity, neglecting the realistic impact of insufficient funds to accommodate requisite toilet facilities. By usable toilets as an initial investment, and by greater extension, overlooking budget constraints for these requisite facilities, Brazil remained unable to sell any tickets. However, the new government remediates some of these issues with project financing—hiring private companies under contract to subsidize buildings. [xi]
[ii] Rowland, Marty, Ph.D, P.E., Passive House Design: Success Record & Cost Differentials, Hagan-CIBER Summer Symposium, Third Leg Consultants, PowerPoint, July 30, 2016, p. 28.
[iii] See GoLogic, The Financial Benefits of Investing in a Passive House, http://www.gologic.us/passivhaus/cost-benefit-of-a-passive-house/, p. 1;
[iv] Rowland, Marty, Ph.D, P.E, McDonald, Timothy, Third Leg Consultants, Construction Cost Summary from PHFA Applications, 2016, p. 1.
[v] Rowland, Marty, Ph.D, P.E., Email Correspondence Explanation with Tim McDonald’s Clarification, August 1, 2016, p. 1;
[vi] ER = X₁[W₁] + X₂ [W₂]= -4/169[.376] + 4/165[.624] = .0011372-
X₁= -4/169 = -2.3669% –> PH Cost-Differential–> 2.3669 % cost reduction;
X₂ = 4/165 = 2.4242% –>Non-PH Cost-Differential;
W₁ = 32/85 = .376–>weight of PH Projects compared to Non-PH Projects;
W₂ = 53/85 =.624àweight of Non-PH Projects compared to PH Projects;
[vii] Kang, Jai, S., Operating Risk & Return in Fixed Cost Spending, PowerPoint, July 30, 2016, p. 18.
[viii] Westerfield, Ross, Jordan, Jaffe, Corporate Finance 11th Edition, McGraw Hill Education, 2016, p. 406;
[ix] See De Feis, George L., D.P.S., Grunewald, Donald, D.B.A., Power, Politics, Protocol of the International Olympic Committee: An Organizational Case Study, July 30, 2016, PowerPoint Presentation, 43 minutes, 23-26 seconds on Recording.
[x] See Westerfield, Ross, Jordan, Jaffe at 212-213;
[xi] Finnerty, John D., Project Financing, Asset-Based Financial Engineering, John Wiley & Sons, Inc., 3rd Edition, 2013.