Lok wants to create value for the company through efficient management of working capital, and prudent capital budgeting activities by expanding the company$$s products into new markets. He is considering a capital investment either in the State of Ohio or North Dakota because of growing market demand for the company$$s products in both States and the recent changes to the States$$ tax legislations that give tax incentives to new companies. The company has announced plans to invest about $$2\mathrm{.}2$ million in its medical devices and pharmaceutical segments. Lok believes that decisions such as these, with price tags in the millions, are obviously major undertakings, and the risks and rewards must be carefully weighed. Lok knows that good financial decisions increase the value of a company$$s stock, and bad financial decisions decrease the value of the stock. Lok is working hard to make Baldwin Inc. one of the leading firms in the health care industry.

Lok has been reading articles in financial journals on capital budgeting decisions and risk analysis. He has written down the following ideas on project evaluation techniques from book chapters and peer$-$reviewed articles:

$1.$ The most popular capital budgeting techniques used in practice to evaluate and select projects are payback period, net present value $($NPV$),$ Profitability Index $($PI$),$ and internal rate of return $($IRR$).$

$2.$Payback period is the number of years required for a company to recover the initial investment cost. The shorter the payback period, the better the project.

$3.$ Net Present Value $($NPV$)$ technique: NPV is found by subtracting a project$$s initial cost of investment from the present value of its cash flows discounted using the firm$$s weighted average cost of capital. It shows the absolute amount of money in dollars that the project is expected to generate.

Decision Criteria of NPV

If NPV $>0,$ accept the project

If NPV $<0,$ reject the project

The decision rule for mutually exclusive project is to select the project with the highest NPV$.$

Exhibit $1$: The expected cash flows in US$ from the project in Ohio and North Dakota.

Year Cash flow $($Ohio$)$ Cash flow $($ND$)$

$0(2,200,000)(2,450,000)$

$1450,000350,000$

$2558,000185,000$

$3562,000205,000$

$4587,000300,000$

$5600,000370,000$

$6625,000590,000$

$7630,000500,000$

$8685,000483,000$

$9690,000480,000$

$10692,000620,000$

The company$$s policy is to select projects using NPV technique and IRR. The cost of capital is $12\%$ for the Ohio project and $10\%$ for ND project.

$3.$ Lok wants to analyze the risk of the project using sensitivity analysis and Monte Carlo simulation.

a$.$ Explain to Baldwin Inc. how the two risk analysis models can be used to analyze risk of the project.

$4.$ Lok has estimated the fixed costs $($including depreciation$)$ of the Ohio project to be $$6$ million, sales price is $$2,000,$ and the variable cost is $$800,$ giving a contribution margin of $$1,200.$ What is the accounting profit break$-$even quantity for this project?

$5.$ Baldwin Inc. wants to know the likely effect of the capital budgeting decision on its stock price $($increase$,$ decrease, no change, or not sure$).$ Choose one and explain why.