UC Baldwin Corp Corporate Finance Risk Analysis Real Options & Capital Budgeting Essay

Assignment 3

RISK ANALYSIS, REAL OPTIONS AND CAPITAL BUDGETING

BaldwinCorporation is a public corporation listed on New York Stock Exchange(NYSE) market. The company researches, develops, manufactures, and sellsvarious products in the health care industry worldwide. Baldwin Inc.operates in three main segments: Consumer, Pharmaceutical, and MedicalDevices segments. The primary corporate objective of the company is tomaximize the value of the owners’ equity by increasing the price of itsshares in the stock market. Unfortunately, the company’s stock price hasbeen declining over the past year because of declining sales, cash flowuncertainties, and weak financial ratios. The Board of Directors havehired a new CFO, Gregg Williams to turnaround the fortunes of thecompany. Gregg earned his PhD in Finance from UC in 2018. After his MBAhe worked for five years as sales and marketing consultant for apharmaceutical company. As a result, Gregg does not have much workexperience in corporate finance, although in his graduate financecourses, he learnt about time value of money and its applications infinancial and investment decisions.

Despitehis lack of experience in corporate finance, Gregg wants to createvalue for the company through efficient management of working capital,and prudent capital budgeting activities by expanding the company’sproducts into new markets. He is considering a capital investment eitherin the State of Ohio or North Dakota because of growing market demandfor the company’s products in both States and the recent changes to theStates’ tax legislations that give tax incentives to new companies. Thecompany has announced plans to invest about $2.2 million in its MedicalDevices and Pharmaceutical segments. Gregg believes that decisions suchas these, with price tags in the millions, are obviously majorundertakings, and the risks and rewards must be carefully weighed. Greggknows that good financial decisions increase the value of a company’sstock, and poor financial decisions decrease the value of the stock.Gregg is working hard to make Baldwin Inc. one of the leading firms inthe health care industry.

Gregghas been reading articles in financial journals on capital budgetingdecisions and risk analysis. He has written down the following ideas onproject evaluation techniques from book chapters and peer-reviewedarticles:

1. The most popular capital budgeting techniques usedin practice to evaluate and select projects are payback period, NetPresent Value (NPV), and Internal Rate of Return (IRR).

2. Payback period is the number of years required for a company to recover the initial investment cost.

3. Net Present Value (NPV) technique:NPV is found by subtracting a project’s initial cost of investment fromthe present value of its cash flows discounted using the firm’sweighted average cost of capital. It shows the absolute amount of moneyin 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) isthe intrinsic rate of return the project is likely to generate. The IRRis the discount rate or the rate of return that will equate the presentvalue 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

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

Year	Cash flow (Ohio)	Cash flow (ND)
0	(2,000,000)	(2,200,000)
1	180,000.00	150,000.00
2	240,000.00	180,000.00
3	280,000.00	200,000.00
4	300,000.00	290,000.00
5	520,000.00	380,000.00
6	480,000.00	590,000.00
7	530,000.00	410,000.00
8	585,000.00	583,000.00
9	590,000.00	580,000.00
10	592,000.00	620,000.00

The company’s policy is to select projects using NPV technique.

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 for the two projects.

b. Calculate the IRR of both projects.

c. 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.Gregg knows how bad forecast can ruin capital budgeting decisions. Ifthe cost of capital changes from 12% to 13% for Ohio project and remainsthe same for ND project, does the company have to pursue the project?

3. Gregg 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.Gregg has estimated the fixed costs (including depreciation) of theOhio project to be $1.5 million, sales price is $130, and the variablecost is $70, giving a contribution margin of $60. What is the 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.