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Case 25: Philip Morris

Capital Budgeting: Projects with Dissimilar Risks


When most people hear the name Philip Morris, they think of tobacco, or
more specifically, Marlboro cigarettes. What most people do not realized is
that the food products Philip Morris markets generate more sales revenue for
the firm. Recognizable brand names include Kraft, Post, Maxwell House, and
Entenmann's. Philip Morris is considering the introduction of two new
products. The first product is a new breakfast cereal called Post Blueberry
Morning. Post is an established name in the cereal market with a market
share of 16.7%. Getting shelf space is extremely difficult and costly for most
new products because grocery stores traditionally charge slotting fees.
Slotting fees are fixed amounts that companies must pay to gain ideal shelf
locations for their products. Post, however, feels less pressure from grocery
stores because of the consumer demand for their products. With the
consumer preference for Post brand cereal, Philip Morris feels that
introducing Post Blueberry Morning will be a low risk venture.
The second new product Philip Morris is considering the introduction of is a
Gourmet Hazel Nut coffee that will be sold under the Maxwell House family
of products. Maxwell House is also established in its market, but the coffee
industry itself is more risky than the high profit margin breakfast cereal
market. Coffee profits are strongly affected by the general swings in the
commodity's price due to uncontrollable factors such as weather. From
month to month the price of coffee fluctuates making profits from coffee
sales fluctuate as well.
In performing a capital budgeting analysis, Philip Morris recognizes that
these two products should not be considered to be of equal risk. Therefore,
traditional net present value analysis should not be used to decide which
product, if any, to produce. To help the company decide how to handle the
perspective investments, their finance department forecasted the projects'
expected net cash flows. Both projects have an expected life of seven years.
Table 1 shows the projected net cash flows associated with both projects.
Table 1
Year

Net cash flow


Gourmet Hazel Nut

Net cash flow


Post Blueberry Morning

-$4,000,000

-$2,500,000

$1,000,000

$803,000

$1,200,000

$521,000

$750,000

$235,000

$950,000

$400,000

$880,000

$498,000

$500,000

$612,000

$206,000

$519,000

Since the two projects have dissimilar risks, the finance department felt it
would be appropriate to indicate how certain they were about their estimates
of the net cash flows associated with each project. These certainty
equivalents are shown in Table 2.
Table 2
Year

C.E.
Gourmet Hazel Nut

C.E.
Post Blueberry Morning

1.00

1.00

.80

.95

.70

.90

.60

.85

.50

.80

.40

.75

.30

.70

.20

.65

The appropriate discount rate for an average risk project for Philip Morris is
10%. They feel that because the Gourmet Hazel Nut project is more risky
than average, a risk-adjusted discount rate of 12% should be used. Finally,
the risk-free rate of return is currently 5%.
Questions
1. If you assume the two projects are of equal risk, what is the net
present value (NPV) of each project? Because the projects are
independent, which project(s) would you accept?
2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV
using the Risk-Adjusted Discount Rate (RADR).
3. Using the certainty equivalents method, calculate the projects' NPV.
Does your accept/reject decision change?
4. Explain the concept of certainty equivalents. Start with a definition and
then explain fully.

5. How do certainty equivalents adjust cash flows for risk and time. How
does this adjustment compare to the way RADRs treat risk and time?