MT499 Unit 5 Options Evaluation With Stress Tests Example

Value, Then Stress, Then Criteria: An MT499 Unit 5 Options Evaluation for Halsey Hearing's Three Answers

[Student Name]

Purdue University Global

MT499: Bachelor's Capstone in Management

Unit 5 Options Evaluation

[Instructor Name]

[Date]

Halsey Hearing and every input, cash flow and present value are composite estimates built from the profile and analysis; the sources cited are real.

Method

Each option is priced on one sheet in the same order: inputs with their basis, five annual cash flows in millions of dollars, and present value at the 10 percent rate fixed in Unit 2. Every input that cannot be read from a filing is an estimate and is marked as one. Three stress tests then break the assumption each option depends on most, and the five criteria from Unit 2 are applied with the weights fixed there. Brealey et al. (2020) treat sensitivity analysis as a way of finding which forecast errors would change a decision, and the stress tests serve that purpose. Koller et al. (2020) add that alternatives should be valued against the same baseline and over the same horizon, which is why all three sheets use five years and the same discount rate.

Option One: Own Brand

Halsey would wholesale a branded pair at an estimated $470 against a cost of about $205. Over-the-counter devices are returned often, so 22 percent returns are assumed, each costing $25 to process, leaving about $156 of contribution per pair shipped. Volumes rise from 55,000 pairs in the first year to 340,000 in the fifth. Launch marketing costs $30 million in year one and $12 million a year after that, a consumer team costs $4 million a year, and new assembly capacity costs $5.5 million in year three because volume passes the plant's spare 247,000 pairs. Clinics are assumed to shift recommendations away from Halsey, costing 1 percent of independent-clinic revenue in year one, 2 percent in year two and 3 percent after that, at the 59.4 percent gross margin. Cash flows run minus $28.5 million, $1.2 million, $6.7 million, $21.5 million and $27.8 million, a present value of $12.0 million.

Option Two: Store Brand

Halsey would manufacture a pair for a national pharmacy chain's label at an estimated $310, earning about $105 over cost and about $95.70 after allowing 3 percent of revenue for defect credits. Volumes start at 55,000 pairs and reach 125,000. Setup costs $4 million in year one and a fourteen-person unit costs $2.5 million a year. Some clinics will notice; a loss of 0.5 percent of clinic revenue a year, about $1.55 million, is assumed. Cash flows run minus $2.8 million, then $4.6, $6.5, $7.4 and $7.9 million, a present value of $16.1 million.

Option Three: Clinic Program

Halsey would spend $9 million a year on training, patient financing and marketing support for independent clinics. Its value comes entirely from what it prevents. Without the program, device sales are assumed to erode by 2 percent a year as first-time buyers move to the consumer aisle; with it, by 0.8 percent. The difference, valued at the 59.4 percent gross margin on $701 million of device sales, gives cash flows of minus $4.0 million, then $0.9, $5.6, $10.2 and $14.6 million, a present value of $17.3 million.

Stress Tests

Each option faces the three tests most likely to break it.

1. Own brand: returns at 30 percent give minus $18.5 million; volumes 30 percent lower give minus $19.9 million; clinic losses of 4 percent from year three give $5.7 million.

2. Store brand: the chain declining to renew after three years gives $4.1 million; volumes 30 percent lower give $5.6 million; clinic losses of 3 percent a year give minus $13.3 million.

3. Clinic program: erosion of 1 percent rather than 2 without the program gives minus $25.4 million; program costs of $11 million a year give $9.7 million; the program slowing erosion only to 1.2 percent gives about zero.

The largest estimate rests on an erosion rate that nobody can observe today.

Break Points

Each option has a value at which it stops paying. The own brand loses its value if returns exceed about 25 percent, uncomfortably close to the 22 percent assumed, or if clinic losses pass about 4.9 percent. The store brand stops paying if clinic losses exceed about 1.9 percent a year, which becomes the number to watch. The clinic program stops paying if erosion without it would be below about 1.6 percent, and that rate cannot be measured until the consumer market has run for several more years.

Criteria Applied as Promised

The five criteria from Unit 2 are scored from one to five without reweighting. On value, weighted 20 percent, the clinic program scores 5, the store brand 4 and the own brand 3. On robustness, weighted 35 percent, the store brand scores 4 because it stays positive in two of three tests, while the clinic program and own brand score 1. On clinic exposure, weighted 20 percent, the clinic program scores 5, the store brand 3 and the own brand 1. On reversibility, weighted 15 percent, the clinic program scores 5, the store brand 4, since a three-year contract can lapse, and the own brand 2. On capability fit, weighted 10 percent, the clinic program and store brand score 4 and the own brand 1. The weighted totals are 3.8 for the store brand, 3.5 for the clinic program and 1.55 for the own brand.

Only a reading that weighs value most heavily puts the clinic program first. Lovallo and Kahneman (2003) describe the optimism that leads planners to trust the forecast with the biggest number, and the criteria were fixed in Unit 2 precisely so that the largest estimate would have to survive its stress tests before it could win.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw-Hill Education.

Koller, T., Goedhart, M., & Wessels, D. (2020). Valuation: Measuring and managing the value of companies (7th ed.). Wiley.

Lovallo, D., & Kahneman, D. (2003). Delusions of success: How optimism undermines executives' decisions. Harvard Business Review, 81(7), 56-63.