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De La Salle University Graduate School of Business 5F, Tower II, RCBC Plaza, Salcedo Village, Makati City Term 1, Academic Year 2017-2018

STARTING RIGHT CORPORATION Case Study

A Course Requirement for MSC530M Section GM91

Fulfilled by: Group 2 Calagui, Irish Margarette Limbauan, Valerie Joy Matias, Renier

Submitted to: Dr. Dennis Berino

September 25, 2017

I.

BACKGROUND: Starting Right Corporation

Inspired by a movie that depicted a woman’s success in a baby food business venture, Julia Day decided to leave the corporate world and to also put up her own. She will call her baby food company as the Starting Right Corporation. To realize this company, Julia needs to raise enough funds by offering aspiring investors different financial instruments such as bonds, common stock and preferred stock and hoping that they invest. Potential investors are namely (1) Sue Pansky, (2) Ray Cahn, (3) Lila Battle, (4) George Yates and (5) Peter Metarko; each of them has different personalities and risk tolerance. II.

CASE FOCUS: Definition of the Problem

Which investment option is the most appropriate for each investor, given each's personal goals and risk aversion? III. CASE FACTS, LIMITATIONS AND CONSTRAINTS ● Each investor should have an annual income of $40,000 and a net worth of $100,000 to be eligible to invest in Starting Right Corporation. ● Three options are being offered to potential investors: corporate bonds, preferred stocks and common stocks. Each investment should be in blocks of $30,000. ● During the next 5 years, inflation is expected to increase by a factor of 4.5% each year. ● Corporate bonds are to receive 13% per year for the next five years and investors are guaranteed to get at least $20,000 back at the end of five years. ● Preferred stocks are expected to increase 4 times with a good market or the value of investment will be reduced to half in unfavorable market conditions. ● Common stocks are expected to increase 8 times with a good market or investors would lose everything in unfavorable market conditions. Risk profile of potential investors: 1. Sue Pansky is considering investing in Starting Right and is very conservative and is a risk avoider. 2. Ray Cahn is also considering an investment, although he believes that there is only an 11% chance of success. 3. Lila Battle has decided to invest in Starting Right. While she believes that Julia has a good chance of being successful, Lila is a risk avoider and very conservative. 4. George Yates believes that there is an equally likely chance for success. 5. Peter Metarko is extremely optimistic about the market for the new baby food. For the summary of payoffs (unadjusted for inflation), see Appendix A. IV. SCOPE and ASSUMPTIONS This case study focuses on decision making under uncertainty and risk. This assumes that only the market favorability affects the success in investing with Starting Right. External factors like management issues are not considered. Expected vesting of gains is five years. Moreover, it was assumed that Julia would still be able to pay her investors by the end of five years and no bankruptcy would happen even if market is unfavorable. This assumption was deduced from the fact that preferred stocks has still their values in an unfavorable market condition in year 5 and in the rule that creditors must all be paid before paying any equity owners. In addition, payoff values used in analysis are adjusted to reflect net present values or the time value of money in relation to the 4.5% inflation. See Appendix B for the description of inflation and the time value of money, and Appendix C for the adjusted payoff values.

V.

ALTERNATIVE APPROACHES TO SOLVING THE PROBLEM

As discussed by Render, et al. (2012), part of the decision making process is the selection of model to be applied to the data. Models depend on the amount of risk and uncertainty, and can be applied using any of the following approaches. 1. Decision table - shows possible values for each combination of controlled and uncontrolled variables. 2. Decision tree analysis - graphical representation of decision table VI. ANALYSIS : THE INVESTORS 1. Sue Pansky (Maximin) A retired elementary school teacher, Sue Pansky is a very conservative and riskaverse investor. To determine which alternative is feasible to Sue Pansky, we use the maximin approach. This is the most appropriate approach for risk avoiders who tend to worry on great losses. We take out the minimum payout for each alternative and then choose. By doing this, we ensure that we make the best out of worst scenarios. Based on our calculations from QM for windows, investing in corporate bonds is our best option using the maximin method. 2. Ray Cahn (Expected Money Value Approach) Ray Cahn is a commodities broker which means he is much more informed regarding investment options. He has stated that the probability of success is 11%. Since Ray is more informed regarding this decision, he might be more cautious regarding the Starting Right as a startup company. We will use Expected Monetary Value (EMV) Approach because the success rate that has been quantified by Ray Cahn. In this computation, the best option is to invest in corporate bonds. EMV takes the inputs from both the possible payouts and their respective probabilities. Ray Cahn’s outlook of success is low, with the chance of success at 11%. This means Ray Cahn may take a more cautious approach in his decision. 3. Lila Battle (Minimax Regret) Lila Battle, a potential investor, believes that Julia has a good chance of being successful. However, despite her optimism, she is still a risk avoider and very conservative, hence, we will use the Minimax Regret method to show her the opportunity loss she incurs if she chooses to be a risk avoider rather than prioritizing the possible payout she can gain in the market. This may encourage her to look at the possibilities of success rather than her risk preference. In this method, we will compute the opportunity loss or the regret of each alternative under each state of nature by

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getting the difference between the payout and the ‘optimal payoff’[1] under each state of nature. In other words, the minimax regret method finds the alternative that minimizes the maximum opportunity loss within each alternative courses of actions. Based on the results, the best option for Lila is to invest in common stocks since this alternative will minimize her opportunity loss to only $41,194.44 thus may encourage more of her optimism about the business’ success rather than following her risk aversion. Alternatively, using the Hurwicz criterion method (see Appendix D), common stocks is still the best option for Lila since she is confident about the success of the market, meaning her alpha is greater than 50%. 4. George Yates (Laplace Approach) George believes that success is equally likely. Thus for him, the favorable and unfavorable market have equal chances of happening. For him, we recommend the use of Laplace the Average approach. This approach assumes equal probabilities for the states of nature and averages payoffs for each alternative. The maximum expected monetary value (EMV) from such payoff averages is chosen. Based on our calculations from QM for windows, investing in common stock yields to the maximum EMV of $66,294.15 given equal chances of success. 5. Peter Metarko (Maximax) Peter Metarko is very optimistic however he is not able to quantify the probability of success. Maximax provides the maximum amount of payout when all possible outcomes has an equal amount of success. From QM calculations, the maximum payout is provided by common stock. This optimistic option will give 800% gain if the company is successful. This will also eventually minimize regret. 6. Julia Day’s decision In order to avoid the the costly development of legal documents for each investment alternative, Julia may opt to remove one investment alternative but should still consider the risk appetite of her prospect and potential investors. She may base her decision by using all the various approaches in decision making and comparing the alternatives to see if which among them will least satisfy investors.

[1]

“Optimal profit” pertains to the best payoff under each state of nature (Render et al., 2012).

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Base on the summary of the different approaches to decision making, Julia may opt to remove preferred stocks in the investment options since it never appeared to be the best option in any of the approaches. Hence, Julia may save on the cost of legal documents for this alternative while still catering on the appetite of risk seeker and risk avoider types of potential investors. Accordingly, Julia’s fundraising will not be materially affected by this decision. VII. ADDITIONAL INFORMATION: Alternative Approaches In our primary analysis, we used decision tables to show and calculate payoffs. This approach is very descriptive. To aid in our analysis, we can also use decision trees which are graphical and schematic (see Appendix F). These are tree-shaped diagrams used to determine a course of action or show a statistical probability. Based on the graphs generated, risk avoiders and conservative investors are likely to choose corporate bonds while risk seekers and optimistic investors are likely to pursue common stocks. Moreover, to provide a more holistic approach towards our decision making, sensitivity analysis may also be employed. According to Render et. al (2012), this determines how much the solution will change if there were changes in the model or the input data. In this analysis, we determined that upon the probability of success/favorable market at 21%, Maximum EMV is given by bonds and by 22%, Maximum EMV is given by common stocks. Therefore, depending on the probability of success and each investor’s belief regarding market favorability, we can suggest them to invest either in bonds or common stock. See Appendix D for the Hurwicz Alpha table and sensitivity analysis. VIII. ETHICAL CONSIDERATIONS RECOGNIZED IN HANDLING THE CASE According to Fisher & Phillips (1992), “ethics refers to the study of what is right or good conduct in a given set of circumstances. Said another way, ethics involves the study of clashes of moral values. Ethical problems exist because we have choices” (p. 4). Thus, in solving the case, ethical standards were considered as further discussed as follow. A. Salary and Net Worth To invest, one requirement is to have at least an annual income of $40,000 and a net worth of $100,000. Also, investments can only be made in tranches of $30,000, which is already 75% of the minimum annual income required. Julia must ensure that her investors would not invest beyond their means and lifestyle. Example of this assessment is of a retired teacher like Sue Pansky. Her retirement funds may really matter as she is no longer part of the workforce and would depend her living solely on her annual pension. For others, investment may be something where they gamble their money on and to some, it is a form of saving. In order to display the consideration of the ethical standards for value of care and justice and fairness in addressing the issue, Julia may opt to lower the amount per tranche. Also, Julia can cater to more interested investors if she will lower, if not remove, her minimum investment requirements. In this way, more people can invest. Through this, Julia not only raises the funds for her Company more effectively, but also helps other investors achieve their personal goals. B. Company Stability and Management Although Julia cannot predict the favorability of market for her product, she can ensure that her business model and all functions of management excel. Although she might have already planned how the company will be realized, she must ensure that each function is implemented well, most especially the production. The product’s quality especially nutritional content must be monitored and honestly communicated with the customers in accordance to the rules of ‘caveat emptor’[2]. A good product encourages customers to patronize such and thus when this happens, Julia may at least control one factor towards a favorable market i.e. customer satisfaction. A favorable market then yields to favorable monetary gains for investors.

[2]

‘Caveat emptor’ is a latin term that means let the buyer beware (Merriam-Webster Dictionary).

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C. Transparency Since the Company is still on its startup, Julia must be responsible enough to be transparent with his potential investors. Infant companies tend to exaggerate their product capabilities and market opportunities in order to impress interested investors. Hence, Julia may desire to overstate the forecasted performance and market share of her product just to lure investors. Potential investors have the right to be fully aware of the reasonable risks and rewards of each investment offered by the Company. Accordingly, risk profile of the decision maker should be met with appropriate quantitative analysis approach in order to create a realistic position over the situation. Also, despite the expensiveness of developing legal documents, the company should comply to all regulations set by the government on its investment vehicles. Legal documents must all be completed and verified by the regulators to validate that the investors are funding a legitimate Company. IX. CONCLUSION AND RECOMMENDATION We were able to determine the appropriate investment options to be offered to potential investors with different risk profiles. Risk avoiders and conservative investors are likely to choose corporate bonds, which is the option with the lowest possible loss. On the other hand, risk seekers and optimistic investors are likely to pursue common stocks since it is the option with the highest payoff. If Julia really finds that legal fees in setting up an investment vehicle too expensive, we recommend Starting Right Corporation to remove the option for preferred stock for now since it doesn’t really fit the risk profile of different investors, which Julia wants to prioritize. On the other hand, investors can also make a combination of corporate bonds and common shares in their portfolio to be able to distribute the risk while achieving their desired level of return or payoff.

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APPENDICES APPENDIX A (Payoff Computation, unadjusted for inflation) DECISION ANALYSIS TABLE (Time value of money not considered) Favorable Market Unfavorable Market Corporate bonds Will earn interest of 13% annually, whether market is favorable or not. (30,000*13%*5)

19,500.00

19,500.00

120,000.00

15,000.00

Preferred stocks Expected to increase by a factor of 4 with a good mark et or the value of investment will be reduced to half in unfavorable market condition. (30,000*4 and 30,000*50%, respectively)

Common stocks Expected to increase by a factor of 8 with a good mark et or investors would lose everything in unfavorable market condition. (30,000*8 and 0, respectively)

240,000.00

Do nothing

-

-

-

APPENDIX B (Inflation and the Time Value of Money) The time value of money refers to the observation that it is better to receive money sooner than later. (Gitman & Zutter, 2012). Inflation on the other hand is a continual increase in price level that affects the real purchasing power of money. (Mishkin, 2013). So how did these two concepts affect our analysis? First, let’s discuss inflation. Given data tells us that inflation shall rise by 4.5% each year. As this increases, the purchasing power of money on the other hand decreases. This means that the amount of a good purchased today would decrease in the future even though the same value of money is used to purchase such. Thus, in our analysis, we determined the value of our payoffs, should they have been received today, rather than in the end of the five-year period; such is the very concept of the time value of money. Adjustment is done to reflect the purchasing value of money in relation today rather than in the future. By doing such to each investor payoff, we can determine the real value[3] of investment today and each investor’s real gain from each investment option. This approach is called the Net Present Value or Discounted Cash Flow Method. This is a very popular capital budgeting technique that determines the value of future cash discounted at a determined rate and period. (Keown, 2007) In our analysis, the determined rate is 4.5% and the period is 5 years. As shown in the Appendix C, payoffs are adjusted and were discounted. Values are different from Appendix A, which shows payoffs unadjusted for inflation-thus shows the future value of money. Computation details and formulas used for net present value analysis are further discussed in Appendix C.

[3]

Real values adjust for differences in the price level. To read more, access the Library of Economics and Liberty(http://www.econlib.org/library/Topics/HighSchool/RealvsNominal.html)

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Through Net present value approach, the real value and purchasing power on each investment option is determined. Doing this empirical approach thus gives us a more meaningful and practical analysis.

APPENDIX C (Payoff Computation, adjusted for inflation of money and used in all computations) DECISION ANALYSIS TABLE Corporate bonds Preferred stocks Common stocks Do nothing

1 2 3 4

Favorable Market Unfavorable Market 11,194.44 11,194.44 66,294.13 (17,963.23) 162,588.25 (30,000.00) -

1. CORPORATE BONDS

Favorable Market

Unfavorable Market

3,900.00 4.38998

3,900.00 4.38998

Present value of interest

17,120.91

17,120.91

Principal Investment value at year 5 PV factor of 1 (4.05%)

30,000.00 0.80245

30,000.00 0.80245

24,073.53

24,073.53

41,194.44 (30,000.00)

41,194.44 (30,000.00)

11,194.44

11,194.44

Interest Annual interest (30,000*13%) PV factor of annuity of 1 (4.05%)

A

B

Present value Total Initial Outflow Payoff on investment

A. Computation for PV factor of annuity of 1 (4.5%) =

1 − (1 + )

where, r = rate per period n = number of periods =

1 − (1 + 0.045) 0.045

= .

B. Computation for PV factor of 1 (4.05%) 1 = (1 + ) where, r = rate per period n = number of periods 1 = (1 + 0.045)

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= .

2. PREFERRED STOCKS

Favorable Market

Unfavorable Market

120,000.00 0.80245

15,000.00 0.80245

Present value

96,294.13

12,036.77

Initial Outflow

(30,000.00)

(30,000.00)

66,294.13

(17,963.23)

Favorable Market

Unfavorable Market

240,000.00 0.80245

0.80245

Investment value at year 5 PV factor of 1 (4.05%)

B

Payoff on investment

3. COMMON STOCKS Investment value at year 5 PV factor of 1 (4.05%)

B

Present value

192,588.25

Initial Outflow Payoff on investment

(30,000.00) 162,588.25

(30,000.00) (30,000.00)

4. DO NOTHING – This option has nil payoff on both of the state of natures. This is because it cannot be assumed that the investor who did nothing at that time will keep his $30,000 up to the end of five years, hence, loss on the time value of money cannot be expected nor computed. Since the investor did nothing on the investment process per se, it doesn’t mean that he will not spend his money on other things nor that he will keep it until the end. Therefore, nil amount of payoff was the best assumption to be used in the decision analysis. APPENDIX D (Sensitivity Analysis) Using QM for Windows, we determined the probability of success (in this analysis, we identify as the Hurwicz alpha) where the maximum EMV changes and therefore the suggested investment changes. Through this table, investors are advised to: 1. put their money on bonds (given the $11,994.4 as the maximum payout upon such probability) when 0% - 21% is the chance of success or favorability; or 2. to invest in common stocks when the chance of success is 22% or higher (given the $12,369.43 as the maximum payout upon such probability)

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The Hurwicz Alpha Table

APPENDIX E (Payoff Computation for Success at 75%)

QM for windows was used in the computation.

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APPENDIX F (Decision Trees) 1. For risk seeker type of investors.

2. For risk avoider type of investors.

3. For average risk avoider/seeker type of investors.

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X. REFERENCES Fisher, B. D., & Phillips, M. J. (1992). The legal, ethical and regulatory environment of business (4th ed.). St. Paul, Minnesota: West Publishing Company. Merriam-Webster Dictionary. (n.d.). Retrieved from merriam-webster.com: https://www.merriam-webster.com/dictionary/caveat%20emptor Render, B., Stair, R., Hanna, M. E., & Hale, T. S. (2015). Quantitative analysis for management (12th ed.). Prentice Hall. Gitman, L.J., & Zutter, C.J. (2012).Principles of Managerial Finance(Global Edition).Philippines: Pearson Education South Asia. Mishkin, F.S. (2013).The Economics of Money, Banking and Financial Markets(10th ed.).Philippines: Pearson Education South Asia. Keown, A.J. (2013).Personal Finance: Turning Money into Wealth (4th ed.).New Jersey: Pearson Education Inc. Real vs. Nominal. (n.d.). In Library of Economics and Liberty. Retrieved from http://www.econlib.org/library/Topics/HighSchool/RealvsNominal.html.

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