18. Limitations of SupraChem Model

 
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Overview

The SupraChem model has a number of limitations, including an inability to deal with price volatility and ignoring the time value of money. Here I explain and suggest remedies for some of these limitations

Lesson Notes

Model limitations

 

1. No accounting for time value of money

- Investment threshold does not recognise the time value of money
- The annual cashflows of the project should be discounted to remedy this problem

2. 10-year time horizon for investment threshold

- Investment threshold imposes a 10-year time horizon, limiting the plant to 7 years of operation
- To remedy this limitation, current investment threshold should be replaced by Net Present Value
- For more information, on Net Present Value, check out this lesson

3. Volatility of market price not modelled

- Model assumes a flat market price for the renewable fuel over the life of the project
- In reality the market price of the fuel will fluctuate substantially over time
- To take account of this fact, our model could use Monte Carlo simulations
- These simulations help evaluate volatility risk, but don't help you predict the future
- We will be covering Monte Carlo simulations in a future course

4. No fixed costs or efficiency gains in cost assumptions

- Our model does not assume any fixed costs, when in reality there are always some.
- Fixed costs can be troublesome in markets with tight margins and high volatility
- Efficiency gains have also been excluded from our cost assumptions
- These gains could easily be added by assuming an annual decrease in $ cost per gallon

Transcript

As with all models, the SupraChem model we've built in this course is a simplified version of reality. It has some obvious limitations that we should flag to the client, before leaving this project. The first limitation relates to the time value of money. Unfortunately, the company's investment hurdle of returning five times the original investment within 10 years is flawed because it doesn't distinguish between cash flows received early in the project and later in the project's life. The time value of money principle states the money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. So in effect, any amount of money is worth more the sooner it is received. To solve this problem, a discount rate should be applied to the annual cash flows. The current chart compares the annual project cash flows with and without a 10%percent discount rate applied. As you can see the value of the annual cash flows decreases further into the future. If you're interested in learning more about the time value of money and discounting cash flows, be sure to check out my upcoming courses on investment valuation. The next problem with the company's investment hurdle is the 10 year time horizon. This allows for only seven years of operation even if the plant is able to operate profitably after this time period. Instead of SupraChem's current hurdle rate, I would recommend using net present value instead to evaluate this investment. Net present value would discount cash flows each year and extend the time horizon according to each scenario and not at some arbitrary time limit. Again to learn more about net present value, be sure to check out my upcoming courses on investment valuation. The next limitation of our model is with regard to the market price for our renewable fuel. Our scenarios currently assume a fixed market price for every year of plant operation.

In reality, however, the market price is likely to fluctuate during this time period, potentially creating losses and large gains during the operating life of the plant.

To account for this volatility, we could add a market price assumption for each year of operation instead of just one constant market price input. The problem with this, however, is that it would be impossible to predict these fluctuations many years in advance. Alternatively, we could run a Monte Carlo simulation based on previous price movements. These simulations will give us a better understanding of the risks associated with such market price fluctuations. It would also help us implement a hedging strategy if we wanted to fix the market price in the near term. A future modeling course will address Monte Carlo simulations in much more detail.

The last limitation of our model is its simplistic cost structure. In our model, we have assumed no fixed costs for our plant when in reality almost all projects will have some fixed costs included. If variable costs make up the vast majority of the total cost, then this assumption is okay, but if not, it could impact our returns especially if market prices are volatile.

Secondly, the model makes no accounting for efficiency improvements during the life of the plant. It's only natural to assume that the plant operators will gradually improve efficiency and hence reduce the cost per gallon over time.

This should also be accounted for in the model. Despite these limitations, the model still provides a lot of value and insight to SupraChem. After reviewing our analysis, the SupraChem executives decide not to proceed with the project.

According to the Director of Business Development, the company is particularly worried about the current market price volatility and given the sensitivity of our final returns to this variable, the company is unwilling to invest in the project any further.

He thanks us for our work which helped identify the key risk factors for the investment and helped the company understand how to evaluate future high-risk investment opportunities.