Several research papers have been examining the relationship between the practical and theoretical application of capital budgeting. The common understanding from these papers is that management apply the basic models and assumptions in their analysis.
However, it seems that they deviate from what may be their understanding of the theory when they apply the actual models onto a project.
For instance, Berg et al. (2013) did a survey on the 500 largest companies in Norway, with the purpose to shed light on how Norwegian companies perform their investment analysis. They observe less differences between how other countries practices than between theoretical and practical approaches. In other words, companies are behaving in roughly the same manner across borders. Furthermore, the paper reveals that the net present value (NPV) method was preferred, followed by the payback method.
Companies also commonly use the WACC, followed by experience and common sense.
An investment analysis is quite often backed up with a sensitivity analysis as an auxiliary method, and 57 % of the respondents from the survey state that they always- or almost always use auxiliary methods to strengthen their analysis. The survey recognizes the fact that the use of real options is almost non-existent and points to two reasons as to why that may be. First, the method is difficult to implement due to the uncertainties underlying the inputs. Second, decision-makers do not have the right knowledge to determine how to apply this method (Berg et al. 2013). If academia assist practitioners to implement theoretical founded models, it could give Norwegian businesses a competitive advantage at a heightened level of precision regarding projects that are accepted or rejected (Berg et al. 2013).
Another study conducted by Graham and Harvey (2001) found that the DCF model was widely used in conjunction with the Capital Asset Pricing Model (CAPM), although more than half of the respondents would use their company’s overall discount rate to evaluate a project in a foreign market. This, despite the threat of different risk attributes, which reveal that practitioners might apply the CAPM or NPV- rule incorrectly (Graham and Harvey, 2001).
1.2 Purpose of the Thesis
This thesis aims to examine the relationship between how an investment is done in practice and how it may deviate from textbook standards. The purpose is to assess an investment decision done by Company X, against established research and discuss any substantial differences that may arise. By using real investment decisions from Company X as an objective to be analyzed, different aspects will be discussed, compared and analyzed extensively.
A typical problem that arises when valuing a project is managing the uncertainty of risk in the cash flows. This is also where the methods used in the analysis tend to differentiate between theory and practice. The purpose is to see if different choices and other assumptions will in fact change the investment decision. Our hope is that this thesis will facilitate a different approach to the research on the gap between theory and practice.
1.3 The Wind Farm Project
Company X is a Norwegian power company specialized in production and distribution of renewable energy, such as hydropower and wind power. Five main business areas unite the organization, although the core business lies within the production department.
This department deals with the operating services within every renewable energy source, and the access to these natural resources are vital for the overall value creation of the company. (Company X, 2017b).
The project to be analyzed is a wind farm investment, strategically located at the coastline of Norway. In total, there is set to be five modern wind turbines, each delivering an effect of 3 megawatt (MW). Put into perspective, each turbine has an hourly effect that exceeds the yearly consumption of a Norwegian family of four (Hafslund, 2017a). A wind farm of this size is expected to last between 20-25 years, but since the Norwegian government give concession rights for a total of 25 years it is desirable to strive for 25 years of production.
Wind power is highly dependent on the weather conditions in order to generate power, and the installations are categorized by a large upfront investment expenditure. In general, wind is impossible to control and for this reason, the installations generate as
much electricity as the weather allows (Vindportalen, 2017). That being said, Norway has a huge amount of unused wind resources. Thus, it represents a good base for wind power investments, which in turn will create attractive jobs outside the major cities and contribute positively to the community (Statkraft, 2017).
1.4 Structure of the Thesis
To be able to substantiate our findings it is necessary to illustrate and explain theories and models used in a transparent way. When comparing an actual investment analysis with the theoretical approach, it is appropriate to build a good foundation for the discussions to come. Our research question will be presented in section 2, together with necessary data and thoroughly explained methods to better understand the thesis as a whole.
As any investment analysis, it is utterly important to connect it with the overall strategic analysis. Section 3 highlights the value drivers and distinct characteristics of the market Company X operates in. The specific investment, external factors and competitive advantage is carefully studied to assess the strategic link. Finally, Company X’s opportunities and threats are highlighted to give an indication if real options can be used to capture flexibility in the future.
Section 4 concerns the actual investment analysis this thesis builds upon. A vital part of Company X’s industry is to predict the future price of electricity and electricity certificates (green certificates). Underlying volatility forecasting and simulations are applied to better understand the magnitude of price uncertainty. Furthermore, operating costs and cost of capital are described in detail. Each subheading will discuss the differences from theoretical and practical approach as they come to light.
In section 5, the findings from our analysis will be discussed and thoroughly assessed against previous research on the theory-practice gap. The focus will be set on key characteristics that differentiates the theoretical analysis by this thesis and the practical analysis constructed by Company X.