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 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, 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 peerreviewed 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.
Cum.
Inflow
(Ohio)
Cum.
PV of
PV of
Inflow
CF (Ohio) CF (Ohio)
(ND)
-2,200,000 -2,450,000
Cash flow Cash flow
(Ohio)
(ND)
PVIF
@ 12%
PVIF
@ 10%
0 -2,200,000 -2,450,000
1.0000
1.0000
1
450,000
350,000
0.8929
0.9091
450,000
350,000
401,786
318,182
2
558,000
185,000
0.7972
0.8264 1,008,000
535,000
444,834
152,893
3
562,000
205,000
0.7118
0.7513 1,570,000
740,000
400,020
154,020
4
587,000
300,000
0.6355
0.6830 2,157,000
1,040,000
373,049
204,904
5
600,000
370,000
0.5674
0.6209 2,757,000
1,410,000
340,456
229,741
6
625,000
590,000
0.5066
0.5645 3,382,000
2,000,000
316,644
333,040
7
630,000
500,000
0.4523
0.5132 4,012,000
2,500,000
284,980
256,579
8
685,000
483,000
0.4039
0.4665 4,697,000
2,983,000
276,660
225,323
9
690,000
480,000
0.3606
0.4241 5,387,000
3,463,000
248,821
203,567
10
692,000
620,000
0.3220
0.3855 6,079,000
4,083,000
222,805
239,037
Year
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?
Ohio
ND
4
6
0.07
0.9
5
7
4.07
6.90
1.50
0.95
22%
9%
$1,110,056 ($132,716)
Accept Don't accept
No. of whole years
Last year fraction
Payback period (whole years)
Payback period (years assuming homogenous cash flow)
Profitability Index
IRR
NPV
Decision
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?
Cum.
Inflow
(Ohio)
Cum.
PV of
PV of
Inflow
CF (Ohio) CF (Ohio)
(ND)
-2,200,000 -2,450,000
Cash flow Cash flow
(Ohio)
(ND)
PVIF
@ 13%
PVIF
@ 10%
0 -2,200,000 -2,450,000
1.0000
1.0000
1
450,000
350,000
0.8850
0.9091
450,000
350,000
398,230
318,182
2
558,000
185,000
0.7831
0.8264 1,008,000
535,000
436,996
152,893
3
562,000
205,000
0.6931
0.7513 1,570,000
740,000
389,494
154,020
4
587,000
300,000
0.6133
0.6830 2,157,000
1,040,000
360,018
204,904
5
600,000
370,000
0.5428
0.6209 2,757,000
1,410,000
325,656
229,741
6
625,000
590,000
0.4803
0.5645 3,382,000
2,000,000
300,199
333,040
7
630,000
500,000
0.4251
0.5132 4,012,000
2,500,000
267,788
256,579
8
685,000
483,000
0.3762
0.4665 4,697,000
2,983,000
257,670
225,323
9
690,000
480,000
0.3329
0.4241 5,387,000
3,463,000
229,691
203,567
10
692,000
620,000
0.2946
0.3855 6,079,000
4,083,000
203,855
239,037
Year
969,597
-132,716 NPV
Yes. Even then NPV is positive, unlike the ND 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.
In a sensitivity analysis, one can understand the risk of the project by understanding the impact of change
of critical variables on the outcome (NPV) of the project. Understanding the potential sensitivity of a
project to a particular variable helps understand the importance of the project variables. This is why it is
also called a “what if” analysis.
Monte Carlo simulation, on the other hand, is a highly is a step beyond by providing a more complete
analysis. It’s a highly probabilistic model, in which interactions within the variables are examined more
thoroughly as the simulation can essentially provide all outcomes that the real scenario can take. This
helps one develop a more robust risk mitigation strategy. For example, a gambler can create a Monte
Carlo simulation to play thousands of hands and form a gambling strategy without losing actual money.
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?
Contribution
Fixed Cost
Break even quantity
$1,200
$6,000,000
5,000
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.
Investing in the Ohio project will have a positive impact on the stock price while investing in the ND
project will have a negative impact. Assuming Baldwin goes with the NPV approach, with other things
remaining constant, investing in the Ohio project should increase the stock price. The cost of capital,
when appropriately estimated, incorporates the risk of the project as well. Thus, investment in positive
NPV projects with such a cost of capital should help increase firm value and thus the stock price.