Case Study: Intro To Applied Finance For Your Client

Case Study Intro To Applied Financeyour Client Was Recently Injured

Analyze three investment options for a client who has received a $1,000,000 compensation payout and wishes to invest for their grandchildren's future. The options include a guaranteed savings account, a property rental and sale scheme, and an olive oil business venture. The report should evaluate each using Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period (PP), and discuss the best investment choice, risks involved, and limitations of these evaluation methods.

Paper For Above instruction

This report aims to provide a comprehensive analysis of three investment options available to a client who has recently received a lump sum of $1,000,000 following an injury at work. The primary objective is to determine the most suitable investment that aligns with the client’s financial goals, risk appetite, and desire to secure their grandchildren’s future. The evaluation employs standard financial metrics—Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period (PP)—to compare the options objectively. Additionally, the report discusses the associated risks, the limitations of these evaluation tools, and concludes with a well-supported recommendation for the optimal investment choice.

Introduction

The decision to invest a substantial lump sum involves careful consideration of various financial metrics and risk factors. For this client, the three potential investment avenues present distinct cash flow patterns, risk profiles, and time horizons. The first, a savings maximiser account, offers fixed annual returns with minimal risk. The second, property investment, combines steady rental income with a future sale. The third, an olive oil manufacturing scheme, involves higher initial risk but offers the potential for greater returns. This report systematically evaluates each option using financial valuation techniques and discusses the suitability of each based on the client’s objectives.

Analysis of Investment Options Using Financial Metrics

Option 1: Savings Maximiser Account

Option 1 involves depositing the entire $1,000,000 into a guaranteed savings account that yields $100,000 annually for ten years, after which the principal is returned. The cash flows are predictable: an annual inflow of $100,000 for ten years, followed by the recovery of the original investment. The NPV calculation, discounted at the required rate of 12%, indicates that the present value of the inflows exceeds the initial outlay, making it a secure, low-risk investment. The IRR, in this case, surpasses the 12% threshold, confirming profitability, and the payback period is exactly 10 years.

Option 2: Property Investment with Rental Income and Sale

This option entails purchasing three rental units for $1,000,000, earning $35,000 in rent annually until year ten, with the units sold for $1,500,000 at the end of ten years. The rental income provides consistent cash flow, and the future sale yields a significant lump sum. Discounting these cash flows at 12% results in a positive NPV, suggesting attractiveness. The IRR calculated from these cash flows exceeds 12%, indicating the project’s profitability. The payback period is approximately 8 years, considering the cumulative rental income and the sale proceeds.

Option 3: Olive Oil Business Venture

This investment involves an initial $250,000 outlay for planting olive trees and establishing the factory, followed by annual investments of $75,000 for ten years. Revenue is uncertain initially, with no oil produced in the first two years, and increasing production from the third year onwards, generating $95,000 of olive oil revenue, increasing by $30,000 annually. The factory is sold at the end of ten years for $100,000. The cash flows are complex, with initial investments, delayed revenues, increasing income, and a terminal sale. Discounting these flows at 12% yields a positive NPV, though a detailed calculation reveals higher risk due to revenue variability and operational uncertainties. IRR calculations indicate profitability but acknowledge higher volatility. The payback period extends beyond seven years, reflecting the time needed to recover investments due to delayed revenue streams and investments.

Ranking of Investment Options

Based on the calculations of NPV, IRR, and PP, the property investment (Option 2) appears the most attractive, offering a high IRR, positive NPV, and a relatively quick payback period. The savings account (Option 1) provides a secure, predictable return but at the expense of lower profitability. The olive oil venture (Option 3) presents the highest potential return but carries significant operational and market risks, making it suitable only for risk-tolerant investors.

Recommended Investment

Considering the client’s objective to preserve capital while securing future benefits for grandchildren, the property investment (Option 2) balances risk, return, and stability effectively. The fixed rental income coupled with a guaranteed sale offers both income and capital gains. Although the olive oil scheme might provide higher returns, its risk profile may not align with a risk-averse investor. The savings account, while safe, may not satisfy the growth and legacy goals.

Risks Involved

Each investment involves distinct risks. The savings account carries minimal risk, primarily inflation risk, which could erode real returns over time. The property scheme faces market risk, vacancy risk, and potential changes in property value, though the contractual rental agreement mitigates some uncertainties. The olive oil business is subject to operational risk, weather variability affecting harvests, market prices for olive oil, and technological risks. Additionally, longer investment horizons increase exposure to economic fluctuations and commodity price volatility.

Limitations of Financial Evaluation Methods

NPV, IRR, and PP are valuable tools but have limitations. NPV assumes the accuracy of discount rates and cash flow projections, which can be uncertain, especially in volatile markets. IRR can be misleading when multiple rates of return exist or when cash flows are unconventional. PP ignores the overall profitability beyond the payback period and does not account for the time value of money accurately in complex scenarios. Moreover, these methods do not incorporate qualitative factors such as market trends, regulatory changes, or management quality, which are vital in real-world investment decisions.

Conclusion

In conclusion, while each investment option offers unique advantages and risks, the property investment (Option 2) emerges as the most balanced choice for a conservative, risk-averse client seeking steady income and capital appreciation. It aligns well with the client’s objectives to secure their grandchildren’s future while minimizing exposure to operational risks and market volatility. Nonetheless, the final decision should also consider the client’s risk tolerance, investment horizon, and personal preferences. A diversified approach combining elements of these options might further optimize the investment strategy.

References

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