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 womans 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 risk-
averse 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 Cahns 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 Days 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, Julias 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 investors 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 products 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
doesnt 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,
19,500.00 19,500.00
whether market is favorable or not.
(30,000*13%*5)
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 120,000.00 15,000.00
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
240,000.00 -
would lose everything in
unfavorable market condition.
(30,000*8 and 0, respectively)
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, lets 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 investors 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

Favorable Market Unfavorable Market
Corporate bonds 1 11,194.44 11,194.44
Preferred stocks 2 66,294.13 (17,963.23)
Common stocks 3 162,588.25 (30,000.00)
Do nothing 4 - -

1. CORPORATE BONDS Favorable Market Unfavorable Market

Interest
Annual interest (30,000*13%) 3,900.00 3,900.00
PV factor of annuity of 1 (4.05%) A 4.38998 4.38998
Present value of interest 17,120.91 17,120.91

Principal
Investment value at year 5 30,000.00 30,000.00
PV factor of 1 (4.05%) B 0.80245 0.80245
Present value 24,073.53 24,073.53

Total 41,194.44 41,194.44

Initial Outflow (30,000.00) (30,000.00)
Payoff on investment 11,194.44 11,194.44

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

Investment value at year 5 120,000.00 15,000.00

PV factor of 1 (4.05%) B 0.80245 0.80245
Present value 96,294.13 12,036.77

Initial Outflow (30,000.00) (30,000.00)

Payoff on investment 66,294.13 (17,963.23)

3. COMMON STOCKS Favorable Market Unfavorable Market

Investment value at year 5 240,000.00 -

PV factor of 1 (4.05%) B 0.80245 0.80245
Present value 192,588.25 -

Initial Outflow (30,000.00) (30,000.00)

Payoff on investment 162,588.25 (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 doesnt 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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