CFINS Chapter 10 Ethical Dilemma Mary Mary Quite Contrary, What Makes Your Sales

Question

CFINS Chapter 10 Ethical Dilemma Mary Mary Quite Contrary, What Makes Your Sales Forecasts Grow? Saskatchewan Mining and Steel (SMS) Corporation is evaluating whether it should produce a new synthetic steel that will require bilons of dollars to develop. According to Bill Bates, the CEO of SMS, the synthetic steel should boost sales such that the company's total new income is increased substantially. Mary, who has worked in the capital budgeting area for six years, has been asked to estimate the relevant cash flows that the synthetic steel is expected to generate. During the past few weeks, Mary has had quite a few conversations with the company's engineers, its production manager, and its vice president of marketing. With the information she compiled through her conversations with these people and additional information she received from independent sources, Mary put together a rather detailed forecast of the synthetic steel's relevant cash flows. The fial report, which includes only the forecasted cash flows and explanations for the forecasts, was submitted to the chiet investment officer yesterday. The report does not include NPV or IRR analysis of the new product because such analyses are conducted by the investment officer Today, the investment officer called Mary to tell her that he thought that the forecasts she submitted were incorrect. Mary explained that her forecasts were based on a large amount of information that she had collected and corroborated in combination with analysts predictions concerning the potential success of the synthetic steel. As she told the investment oficer, her forecasts were based on optimistic growth rates in sales for the synthetic steel during the next 15 years. The investment officer said that he thought the growth of such a revolutionary product could be higher than Mary estimated, so he asked her to reconsider her cash flow estimates. Although she had reviewed the numbers dozens of times and she is convinced her forecasts are reliable, Mary agreed to "go over" the forecasts one more time. Being a team player is important to Mary because she wants to move up the corporate ladder as quickly as possible, and she believes that her rise to the executive suite will be enhanced if she cooperates with her superiors, including the investment officer. Because she set up her forecast on a spreadsheet, Mary knew it would be easy to change the growth rate of sales to get new cash flow forecasts for the synthetic steel. But Mary didn't think that growth rates higher than the ones she used in her original forecasts could be achieved, even if the synthetic steel proved to be a huge success. She did, however use the higher growth rates that the investment officer had suggested and generated a new set of forecasted cash flows for the synthetic steel. Even though she is convinced that the new growth rates are likely not attainable, Mary sent her new forecasts to the investment © 2017 Cengage Leaming All Roghts Reserved. May not be carred. oopied or dupicated, or posted to accessble website, in whole or in part publdy CFIN5 office a litle while ago. She figured, "What's the difference? I don't make the final decision anyway Do you believe that Mary should have changed her forecasts? What would you have done if you were in Mary's position?

Explanation / Answer

The following are the key changes to be done in the sheet as I feel so considering the problem statement.

1. The product is new and hence margins shall be higher in intial period. As more firm see the opportunity, competition begins and the margins go shrinking. Hence the cashflows assumed may be largely unenven. In the said case, instead of a highly optimisitic growth rate it would be better to go with conservative estimates as it shall not be leading to scenrio of overestimating cash inflows and thereby leading to lower IRR under actual scenario (as Mary did).

2. Also being a spreadsheet program, it would be better to do a sensitivty analysis of growth rates and its imapct on IRR and NPV. If the sensitivity is lesser wrt to growth rates considering other operational costs into picture, we can resolve to adopting higher rates as suggested by his superior. If there is a gross variation in NPV and IRR results the same shall be brought to the notice of the investment decsision authority as it may lead to value erosion of share holders money.

Hence if I were in Mary's postion, I would carry out sensitivty analysis and plot the results, if i feel convinced I shall change, else i may report the issue and bring in ncessary checks and balances before reporting to final investment decision authority as it is responsibility of Mary to project both pros and cons of the proposal.

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