FIN 419 Week 1 Risk and Financial Decision Making Example

Sign the Hospital Contract or Pass? How a Commercial Laundry Weighs Risk and Return, Fixed Costs, Customer Concentration and Managers' Incentives Before Committing $5 Million

[Student Name]

University of Phoenix

FIN/419: Finance for Decision Making

Week 1 Assignment

[Instructor Name]

[Date]

Bluewater Linen Services and all figures are composites written for a model paper; finance concepts and research findings come from the sources listed.

Bluewater Linen Services, a composite commercial laundry in Green Bay, Wisconsin, washes linens and uniforms for hotels, restaurants and clinics, with annual revenue of about $18 million and operating profit of $1.6 million. A regional hospital system has offered a seven-year contract worth about $6.2 million a year to process all of its surgical linens, scrubs and bedding. Serving the contract requires a new tunnel washer line costing $5 million, a larger delivery fleet and 30 more employees. The general manager is enthusiastic; the owners, two siblings who inherited the business, are uneasy. A contract that increases revenue by a third also changes what could go wrong, and a good decision starts by naming those changes before running the numbers. This paper frames the decision.

The Goal the Decision Should Serve

In finance texts, a company exists to make the owners' stake worth as much as possible, and that worth depends on the size, timing and risk of future cash flows (Brigham & Ehrhardt, 2022). That goal differs from maximizing revenue or this year's profit. The hospital contract would raise revenue sharply, but it would add value only if the cash it brings, after the investment and over its seven years, is worth more than the $5 million it costs, at a rate that reflects its risk. Owners of a private company also care about their ability to sleep at night and to pass the business on, which is a reason to examine risk carefully rather than a departure from the goal.

Two Kinds of Risk

Business risk is the uncertainty in operating profit, coming from demand, prices, costs and competition. Financial risk is the additional uncertainty that owners bear when the firm borrows, since interest must be paid regardless of results. Bluewater has little debt now. If it borrows most of the $5 million, it adds financial risk on top of whatever business risk the contract carries. Separating the two lets the owners ask two questions: is the contract a good business, and how should it be financed?

Fixed Costs and Profit Swings

A tunnel washer line is a fixed cost: depreciation, maintenance and the minimum crew must be paid whether it runs full or half empty. Laundries with more automation have higher fixed costs and lower variable costs per pound. That structure magnifies profit changes. At current volume, Bluewater's contribution margin is about 40 percent of revenue, or $7.2 million, against fixed costs of about $5.6 million, leaving the $1.6 million operating profit. With the contract, revenue rises to $24.2 million, contribution to about $9.9 million and fixed costs to about $7.2 million, for operating profit near $2.7 million. Spread across the whole business, a 10 percent revenue decline would cut profit by about a third either way. The sharper risk sits inside the contract itself. The hospital work adds about $2.7 million of contribution and about $1.6 million of new fixed cost, including depreciation on the line and a new delivery fleet. If the hospital's volume fell by half, its contribution would drop to about $1.35 million while the new line's fixed costs stayed put, turning an operating gain of about $1.1 million a year into a small loss.

Customer Concentration

Bluewater's largest customer now provides 7 percent of revenue. The hospital system would provide about 26 percent. Concentration adds a risk that averages cannot capture: if the system ends the contract early, merges with a competitor that has its own laundry or demands price cuts at renewal, a quarter of revenue is at stake at once. The contract allows termination for cause and repricing after year four, both of which the owners should treat as real possibilities.

A Scenario View

The finance manager prepared three scenarios for the contract's annual operating cash flow, after taxes and its own costs. In the base case, with a 55 percent probability, the contract adds about $1.64 million a year. In a strong case, with a 20 percent probability, volume runs 15 percent above plan and the contract adds about $1.95 million. In a weak case, with a 25 percent probability, the hospital consolidates two sites in year four, volume drops 40 percent and the annual cash flow falls to about $0.83 million for the remaining years, an average of about $1.18 million over the contract. The expected annual cash flow is 0.55 times 1.64 plus 0.20 times 1.95 plus 0.25 times 1.18, or about $1.59 million. Week 2 will discount these flows; for now the scenarios show that the downside is not a disaster but would leave the investment barely earning a fair return.

Risk and Required Return

Investors and owners require higher returns for bearing more risk. A contract with one customer, high fixed costs and seven-year exposure deserves a higher required return than Bluewater's existing diversified business. The owners' instinct to demand more from the contract is consistent with finance theory: the discount rate should reflect the risk of the project, not the average risk of the firm.

Whose Recommendation Is It?

The general manager's bonus is 1 percent of revenue growth. Jensen and Meckling (1976) described how managers acting as agents for owners may pursue their own interests when those differ from the owners'. A revenue bonus rewards the manager for signing the contract whether or not it creates value. The owners should not assume bad faith, but they should recognize the incentive, ask for the analysis to be reviewed by their outside accountant and consider changing the bonus to reward cash flow or return on investment.

Should the Firm Manage the Risk?

Froot et al. (1993) argued that risk management adds value when it ensures a firm has internal funds to pursue good investments without costly outside financing. For Bluewater, the danger is that losing the hospital contract would cut cash just when the company needs to replace older equipment. Ways to manage that risk include negotiating a minimum volume guarantee, a termination payment that covers the remaining equipment value, or a shorter equipment loan matched to the contract's guaranteed term.

Liquidity and Timing

The contract also affects cash timing. Hospitals often pay in 45 to 60 days, while payroll is weekly. The new employees and supplies would require about $700,000 of added working capital, money tied up before the first payment arrives. The owners need a line of credit sized for that gap.

Conditions for Signing

The analysis does not yet say whether to sign; that requires the discounted cash flows of Week 2. It does set conditions. The owners should sign only if the contract's net present value is positive at a required return above the firm's normal rate, if the hospital agrees to a minimum volume or termination payment covering at least the unpaid equipment balance, if financing does not leave the company unable to cover payments in the weak scenario and if the manager's incentive is aligned with value.

Conclusion

The hospital contract would raise revenue by a third but also increase fixed costs, concentrate a quarter of revenue in one customer and reward a manager for growth regardless of value. Framing the decision around value, separating business from financial risk, quantifying how fixed costs magnify swings and naming incentives gives the owners a clear set of conditions to test before they commit $5 million.

References

Brigham, E. F., & Ehrhardt, M. C. (2022). Financial management: Theory and practice (17th ed.). Cengage.

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X