What is a valuable investment opportunity?

This is a part of upcoming series of posts on Real Estate Finance and Valuation.

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The primary goal of a company/firm is to maximize shareholders' wealth. As shown in figure 1, a firm makes two basic financial decisions:

1. Investment decision
2. Financing decision

Figure 1: Basic decisions of the firm

The outcome of these decisions impact the stock price, and thereby impacts shareholders' wealth. Lets consider the firm's Investment Decision. The investment decision is the answer to the question: what investment opportunities should the firm invest in? The firm needs to identify valuable investment opportunities.

Well, what is a valuable investment opportunity? How will the firm recognize one? What are its salient characteristics?

Suppose you were offered an opportunity to purchase a real estate property for $5,000,000 and you know that you can immediately sell it to another party for $5,500,000. You instantly recognize this as a valuable investment opportunity, because it worth more than its cost. The difference between the investment cost and its worth is the investment's impact on wealth. By purchasing a property in $5,000,000 that's worth $5,500,000 you have increased your wealth by $500,000 (profit). So we can identify a valuable investment opportunity by its monetary impact on wealth. Alternatively, we can also identify a valuable investment opportunity by the rate of return it offers on our investment.

So, how do we know if the rate of return offered by an investment is enough to make it a valuable investment opportunity.

To answer that question, let's introduce one of the most important concept in Finance, the Opportunity Cost of Capital.

Opportunity cost of capital:
The concept of the opportunity cost of capital is often misunderstood. The cost of capital is not the cost of the funds used to finance an investment. It is an opportunity cost of capital. It is the opportunity cost of investing the capital in an investment opportunity, and forgoing the return on an alternative investment in the financial market. Figure 2 explains this concept.

Figure 2: Residual cash flow of the firm (non-financial asset management)

The firm generates residual cash flow, which is the equity cash flow that belongs to the shareholders. The firm can pay it out to the shareholders as cash dividends or it can retain it in the firm. Suppose it paid out to shareholders as cash dividends. Shareholders can have investment horizons that extend over a number of years. So, when they receive cash as dividend from their investment they will re-invest the cash in order to earn a return on these funds over their investment horizon. Shareholders have access to financial markets and to the rates of return offered by the financial markets. So they can re-invest the cash in the financial assets and earn a return on financial assets.

Alternatively, the residual cash flow can be retained in the firm and managers can invest it for shareholders. But managers shouldn't invest that cash in financial assets (expect in case of financial asset management company). They are not paid to do what shareholders can do on their own. Shareholders don't need managers to invest in financial assets for them. They have access to the financial markets and can do that on their own. Besides, managers does not have any particular expertise in investing in financial assets. But managers have knowledge of their firms and industries and experience of development projects, and managing operations that produces good and services at a profit. So their particular expertise is in identifying investment opportunities in real productive assets. So if managers invest cash on behalf of shareholders they should invest in real assets and earn a return for shareholders from these real assets.

Now, which of the two will shareholders prefer. Should shareholders prefer cash and invest on their own in financial markets, or should they prefer managers to invest for them on real assets? Well it depends. It depends on the return managers can earn from the investment in real assets. Shareholders will prefer managers to invest for them only if managers can do better than they can do it on their own. That is if managers can earn a rate of return better than that is available on comparable (comparable in risks on future cash flow) investments in the financial market.

It means that the decision to invest or not invest in the investment opportunity depends on the rate of return from the comparable investment in the financial assets. Return on comparable financial assets form the financial standard against which the alternative investment is evaluated. Only if the return from the alternative investment beats the financial standard, you make the investment.

Return on Real Assets > Return on Financial Assets

The return on financial assets is the opportunity cost in making the investment because return on financial asset is forgone if we make alternative investment. This is what is meant by the Opportunity Cost of Capital.

All investment are judged against their financial standards, i.e. all investments are judged against their opportunity cost of capital.

The important points to understand are:

• Managers are hired to earn return on investment better than the return shareholders can earn on their own in the financial markets.
• The returns in the financial markets provide a financial standard against which all investment opportunities are judged.
• The return forgone on a comparable investment in the financial market represents an opportunity cost of making an alternative investment.
• All investments are evaluated against their Opportunity Cost of Capital.

So, what is a valuable investment property?

1. An investment worth more than its costs
2. An investment with a rate of return greater than its opportunity cost of capital

These two statements are identical. An investment worth more than its cost has a return greater than the opportunity cost of capital. An investment with returns greater than its opportunity cost of capital is worth more than its costs.

These are two definitions by which we can identify valuable investment opportunities.

In the next post we will discuss about some capital budgeting tools to quantify these two definitions.

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All credits goes to Prof. Samuel Szewczyk, Drexel LeBrow College of Business.

USGBC Greenbuild 2011 Social Equity Scholarship

One fine evening, to my most pleasant surprise, I found about my selection as one of the five candidates for the USGBC Greenbuild 2011 Social Equity Scholarship from World Green Building Council (World GBC) to attend World GBC Congress 2011 and USGBC Greenbuild 2011 Conference & Expo. in Toronto, Canada. I remember myself bouncing and jumping all around with joy in reaction to this award. Wow!

I reached Toronto on 1^st October 2011, a day before World GBC Congress 2011. On the first day of the congress, I was exhilarated to see a huge group which comprised members of around eighty Green Building Councils (GBCs) from all over the world, attending and interacting with enormous enthusiasm. There was a profound positivity among the people; everyone was sharing their experiences about the ongoing Green building movement around the world as well as in their countries. Here I met the other four fellow World GBC’s scholarship awardees who came all the way from Tunisia, South Africa, and Trinidad & Tobago. Later in the day, I attended a discussion about the financial challenges which the upcoming GBCs were facing in establishing a market driven model of green buildings in their countries. I was glad to see how older and mature GBCs were helpful in sharing their own learning on how they overcame such challenges in their countries.

The second and last day of the World GBC Congress started with panel discussions and ended up with an award dinner. Here I met the founder of USGBC Mr. David Gottfried and exchanged a few words with him about the ongoing Green building movement across the globe and especially in India.

The next day was the first of the four days of USGBC Greenbuild 2011 Conference & Expo. which was organised in two huge buildings of Toronto Metro Convention Centre. I spent the whole day in the colossal Greenbuild exposition, which was so huge that one needs at least a complete week to visit all the counters. This exposition was my personal favourite, which gave me an opportunity to explore different technologies, which I always wished to understand, such as heat recovery wheel, advanced rain water harvesting system, translucent photovoltaic systems, phase change materials, onsite garbage recycler, outdoor radiant heating systems, green roofs and many more. Apart from the product expo., I also met many professors from different universities such as Prof. Edward Arens, and Prof. Gail Brager from University of California Berkeley and discussed my higher education plans. Later in the day, I met the other twenty five highly motivated Greenbuild 2011 scholarship awardees who were all from different parts of the world. Today even after the Greenbuild, we all are in touch with each other and sharing each other’s progress in the Green field.

Continuing with the Greenbuild - The next three days I attended the following education sessions:

Passivhaus: Bringing German Energy Design Home to LEED

Speakers: Ross Elliott, H Prudence Ferreira, Bronwyn Barry

Can we have our cake and eat it too? Balancing Energy Efficiency and Occupant Comfort

Moderator: Sahar Abbaszadeh | Speakers: Linda Sorrento, Gwelen Paliaga, Dan Int-Hout

Oregon Sustainability Center: A Triple Net Zero Building

Moderator: Dennis Wilde | Speakers: Kyle Andersen, Lisa Petterson, Steve Clem

Implementing Next Generation Cradle to Cradle: Policy & Practice

Moderator: David Johnson | Speakers: Steven Zornetzer, David Orr, David Nieh

Learning from Buildings: Technologies for Measuring, Benchmarking, and Improving Performance

Moderator: Gail Brager | Speakers: Ed Arens, David Lehrer, John Goins

Hospital Configuration and Systems Integration for Reduced Energy Use

Moderator: Andre Kroeger | Speakers: Paul Marmion, Paul Marmion, Dr. Andrew William Woods, Charles Alan Short

Today, back in India, I feel that the whole experience of Greenbuild 2011 in Toronto has motivated me immensely to continue contributing towards Green buildings and sustainability. I am highly thankful to the USGBC, the WorldGBC, and the Indian Green Building Council (CII-IGBC) for providing me this great opportunity. In the last, I would like to say that I will always cherish the memories I received from Greenbuild 2011.

Thank you!!

Vaibhav Jain

Relevance of energy efficiency in buildings for India’s development

Buildings represent around 33% of the electricity consumption in India [1]. An estimated 1.3 billion sq. m. of new commercial floor space will be added in India over the next 20 years approximately twice of what exists currently [2]. The demand-supply gap in electricity and peak power availability continues to widen; while over 40% of India’s population do not have access to electricity [2]. In India, around 65% of electricity is generated by thermal power plants which use fossil fuel as primary energy source [4]. In other words, building industry indirectly holds a major share in CO2 emission which a major reason for climate changes.

None the less is the reason that promotion of research, development, and capacity building in the field of energy efficient and sustainable buildings is one the eight national missions in India’s National Action Plan on Climate Change [3].

Conventional buildings are energy guzzlers but new scientifically designed buildings consume about 40-60% less energy which causes less CO2 emission as compared to conventional buildings [1]. As an estimate, mandatory enforcement of high performance building designs in all new construction in India will yield an annual energy savings of approximately 1.7 billion kWh [1]. Presently this equals to monetary savings of INR 9.6 Billion per year.

This saving is tremendous, and extremely necessary for improvement of India’s GDP and eventually standard of living in India. To achieve this goal India needs a large number of academically sound experts to lead high quality research and development, which presently are scarce in India.

Reference of facts:

1. Energy Conservation Building Code 2009, Ministry of Power, Government of India.

2. ECO-III, US AID INDIA, Net Zero Energy Buildings program, article, http://eco3.org/NZEBs

3. Report, National Action Plan on Climate Change, Government of India, http://pmindia.nic.in/Pg01-52.pdf, Page no. 26

4. Wikipedia article name “Electricity sector in India”. http://en.wikipedia.org/wiki/Electricity_sector_in_India#Generation