Question
3 Company information
Daldorn is a manufacturer of heavy steel items. It is funded by a venture capitalist organisation（VC）. Following a period of poor performance, the VC has expressed concern that Daldorn’s board members are focusing too much on their own interests, while neglecting to adequately measure and manage company performance in respect of other stakeholder groups.
The company has experienced severe cash flow difficulties due to financial losses made on the sale of several new products. These difficulties have been attributed to poor pricing decisions, which were the responsibility of the board and have resulted in many employees losing their jobs.

Key stakeholder groups
The VC has identified three key stakeholder groups at Daldorn:
The board
The VC is concerned that due to the past losses made on several new products, the board has become too cautious in their attitude towards potential new projects and, in particular, to the pricing of new products.
Given the importance of the board to the success of Daldorn, the VC has recently implemented a new bonus scheme. This is an attempt by the VC to revise the board’s appetite for risk and encourage them to take more risks, for example, in deciding on the price of new products. Board members will now receive a very large annual performance-related bonus for Daldorn’s achievement of challenging targets set on the financial performance measure of return on capital employed（ROCE）.
Employees
The manufacturing process at Daldorn does not require employees to have a high level of skill and so most of the manufacturing employees are relatively low skilled. Other employees in other departments have roles which can require specific skills and qualifications. There is a high level of unemployment in the region where Daldorn is based.

Government and regulators
Daldorn operates in a strict regulatory environment. Daldorn has a good record of compliance, but recently its own scientists have discovered high concentrations of a toxic pollutant, which is a waste product from its own manufacturing processes, in the soil near to its factory.
The VC has asked for your advice on whether Daldorn’s existing measures shown in Appendix 1 adequately measure the company’s performance in managing the concerns of each of these three key stakeholder groups. You may justify the use of alternative measures, but the VC wants only one measure for each stakeholder group and is not concerned about the potential conflict between measures at this stage. As part of this work, the VC expects you to briefly comment on the power and interest of the three stakeholder groups.

Pricing decision
Daldorn is about to launch a new product and needs to determine an appropriate price to charge. The variable cost of each product is uncertain and, hence, there are three possibilities for each demand level. The total contribution of the products at the three possible anticipated levels of demand are shown in Appendix 2.
Investment projects
Two new mutually exclusive manufacturing projects, which are totally unconnected to Daldorn, have become available for the VC to invest in. The VC has undertaken many similar investments before and is an almost entirely risk neutral investor.
Two important exogenous（external）variables affecting the net present value（NPV）of the new projects, A and B, are the worldwide demand for steel products and the level of tariffs applied to the import of a key raw material.
The probabilities of these two variables are independent. The VC has estimated the probabilities of there being low, medium or high levels of these two variables in Appendix 3, together with an estimate of the expected NPV for project A for each level of demand and tariff. An analyst has already calculated that the overall expected value of project B is $1,347 million.

Required:
（a）Assess the performance measures shown in Appendix 1 in relation to the three key stakeholder groups as required by the VC.（9 marks）
（b）Evaluate which price the board would choose for the new product based on the board’s revised attitude to risk and briefly comment on the drawbacks of the decision rule used.
（5 marks）
（c）Advise the VC which of the two new investment projects it should undertake, including an evaluation of the appropriateness of the numerical technique used.（11 marks）
（25 marks）

* Total demand for the whole of the product’s anticipated two-year life.
Appendix 3
Project A – Expected NPV（$ million）for each possible demand level and tariff level combination

Notes
（1）The standard deviation of the outcomes for project A has been correctly calculated to be 103 and the standard deviation of the outcomes for project B has been correctly calculated to be 106.
（2）An analyst has already calculated that the overall expected value of project B is $1,347 million.

Answer
3（a）Board
The board members are key players who have a high level of power and interest. It is important that they understand and approve of Daldorn’s strategy. It is vital that they are kept motivated in order to drive Daldorn’s performance. The VC has recently implemented a new reward system, where the board will receive a very large annual performance-related bonus for the achievement of targets on return on capital employed（ROCE）.
ROCE may be an appropriate measure as it will be familiar to the board. It does have some drawbacks as a performance measure, for example, by discouraging investment in new assets. Alternative measures such as economic value added（EVA™）may overcome some of these drawbacks.

Employees
Employees have a high interest as they depend on the company for their income in an area of high unemployment. Most employees are relatively unskilled, and individually have low power, as they could be easily replaced. As Daldorn operates in a strict regulatory environment, employees’ rights are likely to be legally protected which may increase their power.
Employees should be kept informed to prevent them joining forces with more powerful stakeholder groups, such as the regulators or trades unions. Training costs are probably not a suitable measure for the mostly low-skilled workforce, as the manufacturing process does not required a high level of skill. Measures relating to employee productivity may be more useful, because, for example, higher productivity may increase their job security.
Some employees’ roles are more highly skilled and, for them, training costs will be a suitable measure of how well their skills are increased or maintained. The cost of training may not, however, indicate whether the training is appropriate or effective. A more precise measure, such as the percentage of employees achieving a particular relevant qualification or skill level, may be more appropriate.

Government and regulators
There are currently no measures relating to the government and regulators. As Daldorn operates in a strict regulatory environment, this seems inappropriate as breaches in regulations could lead to fines or loss of reputation.
The government and regulators have a high level of power but low interest. To prevent them becoming key players, they should be kept satisfied. This could be done by introducing measures relating to environmental performance, such as the level of toxic pollutants in the soil close to Daldorn’s factory. This would allow Daldorn to take action to reduce the level of pollutants if these approached levels likely to breach environmental regulations.

（b）The board now has very large performance-related bonuses. This will mean that they have a risk seeking attitude to risk, in order to maximise their bonuses. The board would use the ‘maximax’ decision rule, that is, they would choose the price which maximises the maximum contribution. This price is $95,000 which would give a maximum contribution of $55,100,000.
The main drawback of using the maximax decision rule is that it may encourage the board to take excessive risks, as opposed to their previous attitude which was too cautious. The maximax rule also does not take into account the probabilities of each outcome and these probabilities are difficult to determine.

（c）The VC is an almost entirely risk neutral investor. The expected value（EV）approach is appropriate as they will accept the project with the highest expected NPV.
A problem with the EV approach is that it is a long run average which assumes a decision is repeated many times and is inappropriate for one-off decisions. The EV is unlikely to be the actual outcome of the project.
The VC has undertaken many similar projects and, hence, it would be appropriate to use EV. The estimations of the probabilities and the cost of capital are subjective and could be inaccurate. This would limit the effectiveness of the EV approach. The VC is experienced in estimating these probabilities, which would make the results of the calculation more reliable. The EV calculations for the two projects only consider two important exogenous variables. In practice, there are many different internal and external factors which could affect the NPV of the projects.
Answer
The calculations indicate that both projects have the same NPV of $1,347 million（W1）. As a risk neutral investor, the VC would be indifferent to which project to undertake.
The outcomes of project A have a slightly lower standard deviation（103）than those of project B（106）. The spread of possible outcomes is therefore greater for project B, which means that it is riskier. The VC may therefore choose project A. Given that the NPV of the two projects are the same, further work such as sensitivity analysis, or an analysis of the external environment（PEST）, could be done to help the VC make their choice.