1. Executive Summary
A report with results of geological tests in the south of Argentina determined that the area explored seemed to be rich in oil. A cost-benefit analysis needed to be done to make an investment decision for production facilities to extract oil from the ground. Evaluating investment opportunities in emerging markets is a mix of art and science. Unlike CAPM for developed markets, there is no standard pricing model for emerging markets that serves as a benchmark. The proposed models are many and varied, but none has gained wide acceptance and use. Currently, investors, companies, and investment banks use different models, based on different assumptions, and consider different variables. The confusion and controversy that follows is therefore unsurprising. The four models reviewed in the article and the case study underscores at least one important point. Lacking a good underlying theory, it is important to have good reasons to choose one model over the many competing alternatives. Therefore, when evaluating investment opportunities in emerging markets, it is essential to be clear about the factors considered and ignored by each model; to carefully balance the pros and cons of each model; and to evaluate the overall plausibility of each model. And of course, it is essential to perform a thorough sensitivity analysis, which is critical in any project evaluation, but even more so in emerging market.
2. Statement of the Problem:
* The primary problem in the case requires finding out whether Exxon Mobil should invest in an opportunity with an initial investment of $130 million. * Investment opportunity evaluation is different for emerging markets. Apart from the traditional methods like CAPM, there are few other models used for evaluation such as Lessard, Godfrey and Espinosa, Goldman Sachs, and SalomonSmithBarney. Deciding which methodology to adopt for investment evaluation is a key challenge. * Project evaluation is based on the discounted interest rate the project shall get in return. The evaluation models asses and incorporate risk in different ways which yield in different discounted rate. A higher or lower discounted rate of return can both negate the chances of investing in a profitable opportunity. It is imperative to assess project against all four models.
Approach for problem solving
* Each project or investment is evaluated by the company based on the asset in which the money is invested. In addition, investment is based on additional compensation for bearing the risk of the asset. While considering the risk for the asset, all the four methodologies for rate of return were analyzed in addition to CAPM method.
The key issues raised
* Rate of return is additive of risk free rate, world market risk premium, specific risk of investment and additional investment. Rate of return varies by each of the methodologies because operations of companies are governed by the bond market and stock market. * In addition, yield spread of the country related to US (YSc), observation correlation between stock and bond market, ρSB play a major role in deciding the rate of return. The specific nature of project and counting sources of risk all play a deciding role. * The complexity increases since each project has to be considered based on the company’s access to capital markets, susceptibility of investment to political risk and financial importance of the project for the company.
The case contained various financial terms. Even before case analysis it was imperative to have a thorough understanding of the terms like PV, NPV, COC, COE, IRR etc. Most of all it was important to understand the difference between Present Value and Future Value. Books on Project Management were referred (referenced below) and financial terms were studied from websites like Investopedia and Wikipedia. In...