Case 23
23
Evaluating Project Risk
It’s Better to Be Safe Than Sorry!
“It’s amazing how much difference there is in the way proposals are presented at two different firms,” said John Woods to his assistant, Pete Madsen, as he pointed to the stack of capital investment proposals piled on his desk. “We sure have our work cut out for us, Pete. I need you to collect some data for me as soon as possible. ”
John Woods, had recently been hired as the Assistant Vice President of Finance of Mid-West Home Products. His past experience included a seven-year stint with another large consumer products firm. His career had been very successful, thus far, as he had gone from being a financial analyst to an Assistant Vice-President of Finance in a little over seven years. John, who held an undergraduate degree in Accounting and an MBA in Finance from nationally recognized business schools, preferred to follow a conservative policy when analyzing capital investment projects. Most of the projects that he had analyzed and got approved had turned out to be profitable for his former employers.
At a recent meeting of the Capital Investment Committee, which was the primary group responsible for approving proposals at Mid-West Home products, the five divisional managers had presented proposals that had cost estimates ranging from $250,000 to $750,000. All five proposals were shown to have positive net present values (NPVs) and fairly high internal rates of return (IRRs). Moreover, the cost and revenue figures seemed to be conservatively arrived at and all five proposals seemed to have good overall strategic value. However, upon careful deliberation and reflection, it was learned that the divisional managers had used the cost of debt as the minimum acceptable rate of return whilst evaluating their respective projects. The company had issued 20-year, 8% bonds, at par, last year and that rate was used as the hurdle rate under the assumption that additional funds could be raised at the same
Evaluating Project Risk
It’s Better to Be Safe Than Sorry!
“It’s amazing how much difference there is in the way proposals are presented at two different firms,” said John Woods to his assistant, Pete Madsen, as he pointed to the stack of capital investment proposals piled on his desk. “We sure have our work cut out for us, Pete. I need you to collect some data for me as soon as possible. ”
John Woods, had recently been hired as the Assistant Vice President of Finance of Mid-West Home Products. His past experience included a seven-year stint with another large consumer products firm. His career had been very successful, thus far, as he had gone from being a financial analyst to an Assistant Vice-President of Finance in a little over seven years. John, who held an undergraduate degree in Accounting and an MBA in Finance from nationally recognized business schools, preferred to follow a conservative policy when analyzing capital investment projects. Most of the projects that he had analyzed and got approved had turned out to be profitable for his former employers.
At a recent meeting of the Capital Investment Committee, which was the primary group responsible for approving proposals at Mid-West Home products, the five divisional managers had presented proposals that had cost estimates ranging from $250,000 to $750,000. All five proposals were shown to have positive net present values (NPVs) and fairly high internal rates of return (IRRs). Moreover, the cost and revenue figures seemed to be conservatively arrived at and all five proposals seemed to have good overall strategic value. However, upon careful deliberation and reflection, it was learned that the divisional managers had used the cost of debt as the minimum acceptable rate of return whilst evaluating their respective projects. The company had issued 20-year, 8% bonds, at par, last year and that rate was used as the hurdle rate under the assumption that additional funds could be raised at the same