RISK ANALYSIS, REAL OPTIONS AND CAPITAL BUDGETING

Baldwin Corporation is a public corporation listed on New York Stock Exchange (NYSE) market. The company researches, develops, manufactures, and sells various products in the health care industry worldwide. Baldwin Inc. operates in three main segments: consumer, pharmaceutical, and medical devices segments. The primary corporate objective of the company is to maximize the value of the owners’ equity by increasing the price of its shares in the stock market. Unfortunately, the company’s stock price has been declining over the past year because of declining sales, cash flow uncertainties, and weak financial ratios. The board of directors have hired a new CFO, Lok Acharya to turnaround the fortunes of the company. Lok earned his PhD in Strategic Management from UC in 2018. After his MBA he worked for five years as sales and marketing consultant for a pharmaceutical company. As a result, Lok does not have much work experience in corporate finance, although in his graduate finance courses, he learnt about time value of money and its applications in financial and investment decisions.

Despite his lack of experience in corporate finance, Lok wants to create value for the company through efficient management of working capital, and prudent capital budgeting activities by expanding the company’s products into new markets. He is considering a capital investment either in the State of Ohio or North Dakota because of growing market demand for the company’s products in both States and the recent changes to the States’ tax legislations that give tax incentives to new companies. The company has announced plans to invest about $2.2 million in its medical devices and pharmaceutical segments. Lok believes that decisions such as these, with price tags in the millions, are obviously major undertakings, and the risks and rewards must be carefully weighed. Lok knows that good financial decisions increase the value of a company’s stock, and bad financial decisions decrease the value of the stock. Lok is working hard to make Baldwin Inc. one of the leading firms in the health care industry.

Lok has been reading articles in financial journals on capital budgeting decisions and risk analysis. He has written down the following ideas on project evaluation techniques from book chapters and peer-reviewed articles:

1. The most popular capital budgeting techniques used in practice to evaluate and select projects are payback period, net present value (NPV), Profitability Index (PI), and internal rate of return (IRR).

2.Payback period is the number of years required for a company to recover the initial investment cost. The shorter the payback period, the better the project.

3. Net Present Value (NPV) technique: NPV is found by subtracting a project’s initial cost of investment from the present value of its cash flows discounted using the firm’s weighted average cost of capital. It shows the absolute amount of money in dollars that the project is expected to generate.

Decision Criteria of NPV

If NPV > 0, accept the project

If NPV < 0, reject the project

The decision rule for mutually exclusive project is to select the project with the highest NPV.

4. Internal Rate of Return (IRR) is the intrinsic rate of return the project is likely to generate. The IRR is the discount rate or the rate of return that will equate the present value of the cash outflows with the present value of the cash inflows (i.e., NPV = 0).

Decision Rule:

Accept the project if IRR > cost of capital

Reject the project if IRR < cost of capital

5. Profitability Index is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. Accept if PI > 1.0 and reject if PI < 1.0.

Exhibit 1: The expected cash flows in US$ from the project in Ohio and North Dakota.

Year |
Cash flow (Ohio) |
Cash flow (ND) |

0 |
(2,200,000) |
(2,450,000) |

1 |
450,000 |
350,000 |

2 |
558,000 |
185,000 |

3 |
562,000 |
205,000 |

4 |
587,000 |
300,000 |

5 |
600,000 |
370,000 |

6 |
625,000 |
590,000 |

7 |
630,000 |
500,000 |

8 |
685,000 |
483,000 |

9 |
690,000 |
480,000 |

10 |
692,000 |
620,000 |

The company’s policy is to select projects using NPV technique and IRR. The cost of capital is 12% for the Ohio project and 10% for ND project.

1. You have been hired as a financial consultant to help evaluate the project. Baldwin Inc. wants you to do the following:

a. Calculate the payback period (PBP) for the two projects.

b. Calculate the profitability Index (PI) for the two projects.

c. Calculate the Internal Rate of Return (IRR)* *for the two projects.

d. Calculate the Net Present Value (NPV) for the two projects.

e. Use the NPV technique to recommend which investment project it should accept, assuming the cost of capital of financing the Ohio project is 12% and 10% for the North Dakota project?

2. Lok knows how bad forecast can ruin capital budgeting decisions. If the cost of capital changes from 12% to 13% for Ohio project and remains the same for ND project, does the company have to pursue the project?

3. Lok wants to analyze the risk of the project using sensitivity analysis and Monte Carlo simulation.

a. Explain to Baldwin Inc. how the two risk analysis models can be used to analyze risk of the project.

4. Lok has estimated the fixed costs (including depreciation) of the Ohio project to be $6 million, sales price is $2,000, and the variable cost is $800, giving a contribution margin of $1,200. What is the accounting profit break-even quantity for this project?

5. Baldwin Inc. wants to know the likely effect of the capital budgeting decision on its stock price (increase, decrease, no change, or not sure). Choose one and explain why.