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

Question Description

Assignment 3

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, Gregg Williams to turnaround the fortunes of the
company. Gregg earned his PhD in Finance from UC in 2018. After his MBA
he worked for five years as sales and marketing consultant for a
pharmaceutical company. As a result, Gregg 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, Gregg 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. Gregg 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. Gregg
knows that good financial decisions increase the value of a company’s
stock, and poor financial decisions decrease the value of the stock.
Gregg is working hard to make Baldwin Inc. one of the leading firms in
the health care industry.

Gregg
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), 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 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

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. 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. 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 the
Ohio project to be $1.5 million, sales price is $130, and the variable
cost 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.

Prof. Angela

4.6/5

Calculate Price


Price (USD)
$
Need Help? Reach us here via Whatsapp.