Capital Budgeting Under Uncertainty – Humphry Control and Instrument Corporation – Finance Assignment Help

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Assignment Task :
Part A: Capital budgeting under uncertainty  
Humphry Control & Instrument Corporation
In 2016, Fletcher Lester is about to make his first major decision as Chief Executive Officer of Humphry Control & Instrument Corporation, a manufacturer of electronic test instruments and control systems for automated machine tools. The corporation was founded in 2010 by three former employees from a key-player company of the same industry. The company’s records of growth and profitability were extraordinary during the period 2010-2013, with earnings amounting to over $30 million in the third year of operation. Because investors assumed that this earnings trend would continue, the company’s stock sold at approximately 20 times earnings during 2013, e.g., P/E ratio = 20, giving the firm a total market value of $600 million. At that point, each of the company’s three founders held about 10 percent of the stock and had a net worth of approximately $60 million on an initial investment of about $60,000. The remaining 70 percent of the stock was owned by other stockholders, mainly mutual funds and banks’ trustees.
The extraordinary expansion during the first three years of the new company’s life was financed partly by the sale of stock now owned by hedge funds. Most of the bank credit consisted of short-term loans used to finance computer equipment purchased “off the shelf” and integrated into the control systems leased to clients. Each client leased a package that included computer hardware and monitoring instruments plus machine control programs especially designed by Humphry’s programmers to meet clients’ specialized needs.
The three founders made two mistakes. First, they put up their own stock in the company as collateral for personal bank loans that they used to buy the stock of other high technology companies (that also suffered price declines later on). Second, Humphry purchased a large quantity of computer modules just before the announcement that the dominant computer manufacturing company was releasing a new model with operating characteristics that make it incompatible with Humphry’s hardware. Because users of automated machine tools want to be able to take advantage of the latest advances in machine tool and computer technology, Humphry was forced to adapt its old equipment to the new standards at a higher cost (than competitors). It could not recover this cost, though, by charging higher leasing rates. Thus, profits never reached the levels that had been anticipated. At the same time, Humphry had to revamp most of its older computer control programs at considerable cost to run under the new system. The net result was that profits skidded from $30 million in 2013 to $ 520,000 in 2014, then to a loss of $24 million in 2015.
The sharp earnings decline, coming at a time when stocks in the same industry were also weak, drove the price of the stock down from its 2013 high of $200 to a low of $10 per share. The fall in the price of the stock reduced the value of the stock that the three founders had put up as collateral for their personal bank loans. When the market value of the securities dropped below the amount of the loans, the bank, acting under a clause in the loan contrac
Inflows
Cash
QUESTIONS
1. Lester realises how important his first major decision is, not only to Humphry but also to his own future. Therefore, he has asked that quantifiable data upon which he will base his final decision be compiled and presented to him. Such data is in the format shown in Table 2. You must complete the blank cells for all three projects. Based on these data, which project appears to be most risky? Least risky?  
2. Calculate the internal rate of return on each project, based on expected values of the inflows and outflows.  
3. Determine the expected net present value of each project, based on expected values of inflows and outflows. Assume that a 20 percent cost-of-capital is appropriate for Humphry. 
4. With the cash flow patterns given in the case, could the net present value (NPV) and internal rate of return (IRR) result in conflicting rankings?  
5. Is it reasonable to use a 20 percent cost-of-capital for each of the projects? What methods of dealing with risk are available to Lester? Assuming that 20 percent is a reasonable cost-of-capital for an average project in the computer control industry, what are reasonable costs of capital for these projects? Explain your proposed calculations and discuss other required information, if any. 
6. Assume that Lester instructs you to use different risk-adjusted discount rates for each project, and that he suggests that 14 percent is reasonable for Project A, 20 percent for Project B, and 28 percent for Project C. Calculate the risk-adjusted net present values for each project. Do conflicting rankings for the risk-adjusted NPV and IRR occur? If 20 percent is used to evaluate B, what costs-of-capital for A and C would make them appear equally as good as B?  
7. Assume that Lester’s job as president of Humphry Control & Instrument Corporation is to maximize the value of the firm and thereby maximize the stockholders’ wealth. Disregard his personal situation and feelings. Which approach do you think should be taken-an aggressive one or a conservative one? Now consider how Lester’s personal situation might affect his decision; that is, could his personal situation cause him to make a decision that is not in the best interest of the stockholders? Which of the projects should Lester accept under each assumption?
 
8. If the returns from Projects A, B, and C had strong negative correlation with the normal expected earnings of most firms in the economy would this affect your
estimates of expected NPV? Would you still consider the most risky project you answered in Question 1 to be the riskiest project? How would it affect the overall riskiness of the firm? The overall cost-of-capital? 
 
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