Capital Investments in Emerging Markets

Capital Investments In Emerging Markets: Johnson Controls

ACC 560

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Executive Summary

Emerging markets had always been the favorite investment destination of multinational corporations. The companies tend to invest in emerging markets as emerging economies offer growth and diversification with high rewards. The countries that are having high economic growth and are in transformation phase are regarded as emerging economies. Corporations make capital investment in these countries to reap high profits. China, Brazil, India, etc. are some of the examples that have undergone explosive growth during the past decade. Rovnick, N. (2016) opined that from the year 2002, Brazil came out as emerging market and was in boom till 2011 because China’s growth began to flatter. The other reason of diversifying in these countries is that the risk of downturn in one economy of one region can be offset by growth of the other region. But investing in these economies also invites some risks that the companies can foresee in near future. It requires analysis of the prevailing conditions in emerging economies and to supplement traditional methods in order to reduce risk. This paper attempts to give supplement on the traditional methods that the companies can use to minimize risk at the time of making investment in emerging economies. It also analyzes the potential impact of inflation on planned capital investments as well as defines approach to make an accurate assessment of investment.

Introduction to Johnson Controls

Johnson Controls is a United States based Multinational Corporation that manufactures automotive parts. The company was formed in 1885 in name of Johnson Electric Service Company. The primary business of company was to manufacture and install automatic temperature regulation systems. In 1974, the company was renamed as Johnson Controls. Headquarters of the company are located at Glendale, Wisconsin, United States. Alex Molinaroli is the Chief Operating Officer and Chairman of the company. The company was at 67th position in fortune 500, 2012 list. The company operates worldwide and has more than 1,300 locations in different countries. The primary products of the company are batteries, car belts, HVAC equipment, car seats, facility management, etc. It employs more than 170,000 employees. The stock of company is traded at New York Stock Exchange and is also component of S&P 500. Its ticker symbol is JCI.

Methodology To Supplement Capital Investment

The traditional methodologies refer to the old and orthodox methods of evaluating capital investment that primarily include replacement cost, valuation methods and transaction. These three valuation methods are used for analyzing almost all the investment decisions and are still vital for making investment decision in other economies. But, over the time, a number of methodologies of evaluation of capital investments have been developed that supplement the traditional methods. These methods take into consideration the future contingencies or the events that may arise any time or may not arise. They plan for both the aspect of the contingencies. Few of these supplemental methods include Monte Carlo Simulations, Real options and Binomial Models which are based on decision tree model. These models include two step processes for facilitating decision making for investment in emerging economies. The first process includes the computation of the probability of making the event favorable that can make the investment portfolio valuable. The second method includes calculation of the payoff in case if the event that is favorable occurs. Thereafter the product of probabilities and cash flow estimated is taken to derive expected cash flow. It is to be noted that these methodologies are used using any of the three traditional methods.

Monte Carlo Simulations

Monte Carlo is a method of solving the statistical problems by using random sampling of inputs. Simulation gives a representation of the investment problem. Monte Carlo Simulation is a technique that gives result of the problem by using a number of inputs again and again. Gapenski, L. C. (1990) suggested that “In a Monte Carlo simulation, relatively certain input variables are specified by single values, while relatively uncertain variables are specified by probability distributions. The end result is a probability distribution that describes the project’s full range of potential profitability.”

Real Options

Real options method is a valuation model that is used for pricing options of the stocks. It is used for the analysis of calls and puts options. This valuation model analyzes the investment made with an asymmetric payoff will lead to increase in the level of uncertainty. It means that it provides with large payoff that is limited in losses. The level of uncertainty is also known as volatility. Thus, the real option method is useful in analyzing the large capital investments that are highly uncertain and the payoff is also not certain or is far away.

Binomial Expansion

The third method of evaluating the capital investments is the binomial expansion method. It is also known as decision tree method and is most instinctive among these three methods. In this method all the events and decisions are analyzed unambiguously along with their probability. It takes into consideration all the potential alternatives that are available as well as the scenarios in which these alternatives are to be used.

All of the above discussed methods require a careful usage. The perception and the intuition behind these methods are difficult for the reader to follow. The understanding of the approach and purpose for which the valuation is carried is the main objective of analysis. These methods require great care to make the models as these models are highly sensitive to the changes in parameters and assumptions that are taken for deriving the investment decision.

The method that can be suggested to Johnson Controls is the binomial expansion that uses decision tree to arrive at investment decision. The binomial model makes the assumption that the asset will either make an upward movement or will move downward on the basis of the probabilities. It undertakes forecasting of future results along with assigning probability of every event to occur. This method analyzes every decision and event with its probability to occur explicitly.

Potential Impact of Inflation

Inflation refers to the increase in the price level and is measured in terms of percentage annual increase. In other words it could be said that inflation is decrease in the value of money. Inflation is a universal process and occurs in every country. The percentage of inflation of the countries varies depending on the various factors. From the capital investment point of view it becomes critical to consider the rate of inflation at the time of planning capital investment. The potential impact of inflation in making investments in emerging economies is that they generally have a higher inflation rate and the value of the capital investment tends to decrease fast by passage of time. It is important for Johnson Controls to make critical analysis of the rate of inflation in the target country where the company is going to make investment. If the rate of inflation is high Johnson Controls should undergo least capital investment and should make assets by way of leases. The other potential impact of inflation is that due to decrease in the value of money the labor demands for more wages to meet their livelihood. In long term perspective it turns to be a high expenditure and the outcome is unexpected losses.

Approach to Perform an Accurate Evaluation of the Investments

Time value of money is one of the approaches that should be performed at the time of making evaluation of an investment. It makes a comparison between the worth of money to be received today with the worth of money to be received in future as the value of money declines due to inflation. The important element that time value of money considers is the opportunity cost. It is the loss of missing an opportunity over exercising another opportunity. Capital investment decisions involve making the calculation of the loss that the company will sustain in choosing one opportunity over the other. It also makes a comparison between present value of money and its future value. The present value is the money that will be spent on capital investment whereas the future value includes the element of interest with the present value. The choice of investment decision for Johnson Controls depends on future value of the investment. If the future value of investment is more than the present value then the company will like to make investment.

Modifications In Evaluating Projects

The modifications in evaluating projects to enhance the capacity in North America with that of expansion in global market needs a careful assessment of the projects. There are a number of pros and cons in increasing capacity in North America as compared to any other emerging economy. In the same way emerging economies also have their pros and cons. The primary advantage of expanding in North America is that the company can exercise an effective and efficient control on functioning. The rate of inflation is also low in North America as compared to emerging economies. It has more political and economic stability which are vital for survival of the projects. The cons of investing in North America are high labor cost, and high transportation cost in delivering goods worldwide. The prime advantage of making investment in emerging economies is to grab the readily available market. The company can serve its customers with low transportation cost by operating domestically in emerging market. The other attraction in emerging economies is the low labor cost as well as the subsidies that the government offers. The major disadvantage is lack of infrastructure, political and economic instability, etc.

This information will facilitate the Johnson Controls in assessing the long-term advantages that it will derive from investing in emerging economies. The multinational corporations always try to increase their market share worldwide, same is with Johnson Controls. Undergoing capital investments in emerging economies will enable the company to exploit business opportunities and to earn more profit by serving the ready market and taking advantage of low labor cost.

Sensitivity Analysis And Its Benefits

Sensitivity analysis technique is used to find out the impact of an independent variable over a dependent variable. It takes into consideration a set of assumptions before yielding results. Saltelli, A. (2004) suggested that “Sensitivity analysis should be considered a pre-requisite for statistical model building in any scientific discipline where modeling takes place.” Sensitivity analysis can be used by Johnson Controls to check the sensitivity of the project, if any of the projected variable changes. The prime advantage of sensitivity analysis is that it will enable the company to identify the variables that can impact the forecasted cash flows and will enable the company to understand the investment. The other advantage is that it will help the company in identifying inappropriate forecasts and will enable the management to focus only on the related variables.

Sensitivity Analysis and Competitive Advantage

This approach will facilitate the management to concentrate on the opportunities that will enable it to improve its profitability as well as cash flows. The company can make an assessment of the incremental value by looking into the historical range of variables and can effectively make profitability and cash flow projections. It will also facilitate the company in determining the uncertainties that are crucial to decision making process.

References

Gapenski, L. C. (1990) Using Monte Carlo Simulation To Make Better Capital Investment

Decisions. Retrieved from: https://www.ncbi.nlm.nih.gov/pubmed/10104380

Rovnick, N. (2016). Investing In Emerging Markets: Time To Buy? Retrieved from:

https://www.ft.com/content/0d7788fa-d955-11e5-a72f-1e7744c66818

Saltelli, A. (2004) Sensitivity Analysis In Practice: A Guide Of Assessing Scientific Models.

John Wiley & Sons. Retrieved from: https://scholar.google.com/citations?view_op=view_citation&hl=en&user=vqhLsGkAAAAJ&citation_for_view=vqhLsGkAAAAJ:HbR8gkJAVGIC