Investment Science Published
The text, Investment Science, was published by
Oxford University Press in early June this year. This is good news
to the students who in the past have had to put up with preliminary
versions. The book can be purchased through the web at Amazon.com
or through many bookstores.
Order Investment Science from Amazon.com
Here
Short
Course News
The new concepts introduced in Investment
Science for Industry have been extremely well received.
Participants are particularly pleased with the tworate method of
discounting, and the Double Step method. The tworate method is
simple and can be applied to many common investment situations. (It
is discussed later in this newsletter.) The Double Step method is a
revolutionary way of presenting and calculating modern optiontype
analysis. Originally, option theory was expressed in terms of the
BlackScholes equation, a differential equation that is beyond the
mathematics familiar to most practitioners. The introduction of
lattice methods was a tremendous step forward in terms of clarity
and computational simplicity, although the required riskneutral
probabilities were difficult to understand because they were not
directly related to normal discount factors. The Double Step
method, on the other hand, expresses results in terms of familiar
discount rates, easily understood by participants. The method is
also easy to implement with simulation. The course has also added
new examples from industry, and more are being added each time the
course is taught.
November and April
Investment Science for Industry will be
offered at Stanford November 1213, 1998 and April 2223, 1999.
Past participants are encouraged to bring this course to the
attention of their colleagues.

Projects
Several projects with industry that are
followups to the short course are currently underway at Stanford
or with closely affiliated companies.
The project with Chevron focused on the cycles in the
petrochemical industry. This work has led to a new fundamental
understanding of cycles and, most importantly, to the development
of strategies to use in cyclic industries.
Applied Materials has used investment science to
investigate the economics of a new product in the dynamic
environment of the semiconductor industry. Hewlett Packard used
investment science to develop a method for evaluating commodity
contracts.
The Energy Policy Research Institute (EPRI) is using
investment science to evaluate the profitability of power plants in
Poland. Enron Capital and Trade has sponsored research at
Stanford on foreign investments subject to specific country risk as
well as other technological and market risks.
Investment Science is applicable to a wide
assortment of business issues. We have found especially strong
interest in the following:
Project Evaluation. This is perhaps the
core issue of many business problems. The question is often posed
as "What is the correct discount rate for my project?" Of course,
the issue is usually not that simple, as anyone who has taken the
course Investment Science for Industry understands.
Real Options. Increasingly, people are
aware that the options implicit in business often provide value.
These "real options" include options to terminate the project if it
goes poorly in the first phase, options to reduce or increase
commodity order magnitudes, options to accelerate a project, and so
forth. The presence of uncertainty actually increases value when
options are available.
Portfolio Selection. Many firms are
faced with dozens of potential projects every year, and not all can
be funded. However, the projects often have interacting effects or
correlations with various market segments. A sound basis for
selecting among such projects is provided by investment science
concepts.
Business Valuation. Methods for
valuation of an entire business or firm is a topic of considerable
importance and one of considerable debate. Traditional methods of
discounted cash flow or use of comparables are of only limited
value. Investment science can provide a new solid foundation for
valuation based on how the market values growth and
uncertainty.
Cycles. Industries requiring large
capital investment are typically characterized by business cycles,
caused by periods of relatively heavy investment followed by
periods of low investment. If these markets are highly competitive,
the average participant will lose money on average. Cycles cannot
be predicted accurately, but they can be characterized
statistically, and optimal investment strategies can be
developed.
Growth. A key measure of business
success is its growth ratemeasured perhaps in terms of the growth
in book value. The STAR method, a new tool of investment science,
characterizes current growth and relates new projects,
acquisitions, options, and debt to changes in overall growth. This
tool can be used strategically to shape the tradeoff between
average growth and the risk associated with that growth.
The TwoRate Method of Discounting
One of the simplest ways to improve
conventional discounted cash flow analysis of projects is to use
two discount rates instead of one. The method is intuitive, simple
to implement, and in some cases can give vastly improved results
compared to using a single rate. Very often, projects will be found
to be less attractive when properly analyzed than when a single
discount rate is used.
Here is how to use the method. Many
projects have two types of risk:

Revenue Risk (a combination of price
and volume risk)

Cost Risk (often associated with the
technical risk of new products).
In some cases only one of these
categories is actually risky, in which case the riskfree component
is considered as one of the categories.
For example, the output of a factory
producing a wellestablished product may be subject to substantial
price risk (common in semiconductor and petrochemical industries,
for example). The costs, on the other hand, may be relatively
nonrisky. In this case the two categories of risk are that
associated with price and the riskfree category of
costs.
As another example, an electric power
plant may have a contract to deliver a fixed amount of power over
several years at a predetermined price, but future fuel costs may
be uncertain. In this case the revenue category is riskfree and
the cost is associated with the risk of fuel cost.
When components of cash flow divide into
two categories, it is natural to assign different discount rates to
each of the categories. If the component is risk free, then the
obvious rate to use is the risk free discount rate (around 5% to
10% these days). If the component is volatile, then it is
appropriate to use the appropriate rate, determined usually by the
market.
Some volatile components should also be
discounted at the riskfree rate. This is true if the risk is
independent of anything in the market. For example, technical risk
or risk associated with unique private assets should be treated as
if they are risk free if they constitute only a small (or medium)
portion of a firm's total business portfolio. These private risks
are automatically diversified if they are a small portion of the
business. The classic example is the amount of oil at a particular
oil well site. This amount is a private risk whose expected value
should be discounted at the riskfree rate, provided it is but one
of several projects at various unrelated sites.
If the risk is related to traded assets,
then the market gives the appropriate discount rate. For example,
if the risk is that associated with the price of semiconductors,
then the average growth rate of a semiconductor stock index would
serve as an appropriate interest rate for the discount
factor.
Example.
Suppose a firm is planning to build a new plant that will produce
10,000 units per year for the next 5 years. The price of these
units has a volatility of 20% and mirrors the volatility of a stock
index for the industry. The cost each year is fixed. The expected
cash flows are shown in the spreadsheet below.
Year

0

1

2

3

4

5

Expected Price

0

20

22

24

26

29

Expected Revenue

0

200,000

220,000

240,000

260,000

290,000

Fixed Cost

500,000

10,000

80,000

80,000

80,000

80,000

Simple Project. The price is uncertain but is
expected to increase. The costs are fixed.
Traditionally, this project might be
analyzed by a singlerate discounted cash flow analysis. In such an
analysis the yearly profit is determined and the then discounted.
The discount rate is subject to debate but in this example an
analyst might try 15% since that is a blend between the volatility
of 20% and the fixed rate of 5%. This analysis, shown in the next
spreadsheet, concludes that the project is profitable.
Year

0

1

2

3

4

5

Expected Price

0

20

22

24

26

29

Expected Revenue

0

200,000

220,000

240,000

260,000

290,000

Fixed Cost

500,000

10,000

80,000

80,000

80,000

80,000

Profit

500,000

190,000

140,000

160,000

180,000

210,000

Discounted Profit

500,000

165,217

105,860

105,203

102,916

104,407

NPV

83,603






Traditional Analysis. Discounting profit at 15%
implies that the project is profitable.
In the tworate method, we discount revenue at
its natural rate of 20% and we discount the fixed costs at their
natural rate of 5%. Then we sum up the difference. This is analysis
is shown in the next spreadsheet. This analysis shows that the
project is unprofitable.
Year

0

1

2

3

4

5

Expected Price

0

20

22

24

26

29

Expected Revenue

0

200,000

220,000

240,000

260,000

290,000

Discounted Revenue

0 
166,667 
152,778 
138,889 
125,386 
116,544 
Fixed Cost

500,000

10,000

80,000

80,000

80,000

80,000

Discounted Cost

500,000

9,524

72,562

69,107

65,816

62,682

Tworate Profit

500,000

157,143

80,215

69,782

59,570

53,862

NPV

79,428






TwoRate Method.
The expected revenue is discounted at 20%
because that is how the market values that uncertainty. The fixed
costs are discounted at 5% because that is the rate for fixed cash
flows. The discounted cost is then subtracted from the discounted
revenue to obtain the final value.
There are two ways to see why the results
differ the way they do. First, fixed costs are not discounted as
heavily in the tworate method as in the singlerate method, and
hence the present value of the costs are higher than with the
earlier method. Likewise, the revenues are discounted more heavily
in the tworate method, and hence the present value of revenues is
less than with the earlier method. As a result of these effects,
the net value of the project is lower.
A second interpretation is that when fixed
costs are subtracted from revenue, the resulting profit is more
volatile than revenue itself. Higher volatility reduces the
desirability of profit, and hence the appropriated discount rate
should be greater than the 20% rate appropriate for revenue, not
lower. Indeed, in this example a single discount rate of 30% will
give approximately the same value as the tworate method. However,
the 30% figure cannot be determined before the analysis is
conducted because it depends on the pattern of revenue and fixed
costs. The tworate method always gives the correct result.
