Issues Identified Essay
1) The first issue of the case is whether Harry Hepburn, the president of Southern California Division of Robinson Brothers Homes should make the projection on the specific project more optimistic or not. By making the revenue forecasts more optimistic, the most likely outcome is that the project will be undertaken and his team of employees will keep their position. Otherwise, at the current estimated return projections, the project is expected to be declined, and Harry’s team will be partially laid off in accordance with the Robinson Brothers Homes plan on cutting costs as the company faces the slowing down market and decreased profitability. 2) The second issue of the case is to evaluate what can be done to either decrease the required IRR benchmark related to this project or to increase the expected IRR of the project.
Due to decreasing margins on their recent construction projects RBH needs a project to bring their revenues and profits up for the upcoming years. RBH’s Southern California division (one of 15) and its VP Michael Borland have come up with a prospective project “The Platinum Pointe Land Deal” which has potentials to increase profits and revenues. The issue with it remains is that the project has a IRR of 21 and for a project like this Michael Borland and his division has calculated a required IRR of 24.5.
Both issue seem to be equally important, however it seems that IRR issue should be attempted to be resolved first: if the required IRR can be lowered without making the forecast too optimistic, Harry will not need to solve this difficult ethical dilemma at this moment.
* Increase IRR
* Decrease required IRR (risk)
* Don’t’ change
1. Harry submits the forecast as planned.
Consequences: project will be rejected and the division will be downsized
2. Harry makes the forecast more optimistic.
Consequences: Project gets funded and employee layoff could be averted. RBH would lose credibility with joint venture partner if the project earns less than the forecast. And some problems in ethical position.
Evaluation of Alternatives:
Way to increase IRR/decrease required IRR:
[As Harry directly supervises the executives and the issue is about financial returns, the results control is the most appropriate for this issue.] 1) Let VPs know about the problem and the fact that this project is critical for the continuity of the division as is. VPs are: Operations, Sales and Marketing, Land Development, Land Acquisition, and Accounting. This understanding will help to establish the link between performance and compensation. 2) Together, they should come up with ideas and set specific goals for increasing IRR and/or lowering risk of the project in their functional areas. The targets set for VPs should be aligned with their functional areas/responsibilities as much as possible. If some targets involve more than one area, they should know specifically with whom should they cooperate to achieve success on that mutual goal. The idea behind it is that VPs should know specifically how can they influence the project’s IRR and risk, so they would feel responsibility and ability to influence and achieve their own specific targets. Second, the goals have to be as specific as possible, so that VPs would know how much more effort should they put to succeed.
Specific possible solutions:
* By not making the purchase (investment) until all political issues are resolved (June 2007 is the expected date), the political risk can be decreased to minimum saving 1.5% in required IRR. * With the appropriate goals and strict incentives are set for VPs as discussed above, the risks in development, market, and financial areas may be reduced by further cumulative 1.5%. Measures to be taken may include: hedging the interest rate risk with derivatives (financial), making early sales (market), securitization of debt (financial), overseeing the construction process thoroughly to ensure its timeliness (development), etc. It is important that other projects of this division, which are currently under way, would not be neglected or paid less attention to. They are also crucial for the division’s success (637 homes in 2006 and $235 in revenue). Harry should oversee their work in order to ensure that no risk manipulation and unjustified assumptions/forecasts take place.
[There are really no alternatives for this issue – there is only a question: “Should Harry stretch the forecast a bit or should not?”] * Harry’s action of making the forecast a bit too optimistic will not be left unnoticed by VPs. As a result, they may begin making dishonest acts on their own in the future acting on the example set by the president. (The cultural control may get broken.) * The management owns the fiduciary duty to its shareholders, as it is trusted with assets to manage. Shareholders interests should be put ahead of their own. According to the stockholder ethical model, the maximization of shareholders’ profit/wealth is of utmost importance. * Southern California Division of RBH represents a large portion of company’s business: in 2006 it is projected to sell 637 homes, while 2000 were built by RBH in total.
Thus, the failure in this division may cause the financial difficulties on the company-wide level affecting other employees as well. According to the stakeholder ethical model, the acceptance of the project of higher risk would also be unethical. * If they accept, then in case of the unfavourable scenario, the company is likely to sell this project at a larger loss, as other development companies are likely to employ the similar IRR model for determining projects’ NPVs. Possible conclusion: in this case, under both stockholder and stakeholder ethical models, the project with the higher risk than required should not be accepted.
Move discussion of incentives part from alternatives evaluation to here. * additional discussion on ethics (evaluation of alternatives) * additional discussion on IRR ((evaluation of alternatives) * implementation details
RBH is a medium-sized homebuilder. The company built single- family and higher-density homes, such as townhouses and condominiums. Its headquarters staff located in Denver, Colorado, and 15 divisions located in most of the metropolitan areas.
2. Problem Statement and Analysis:
The market of the Southern California Division served had slowed, the division has to make price concessions in order to sell its homes. However, the construction costs were continuing to rise. Action controls: reduce cost , budgets , review and approval Harry wants to do the project (Platinum Pointe) which promises to provide over $100 million in revenue and nearly $ 14 million in profits in the 2008-11 time period. But the IRR of the project is only 21%, which is below the minimum required for a project with this level of risk – 24.5% ————————————————-
The stock price had declined almost 50% from the all- time peak in 2005.
Each division was self-contained, with its own construction supervision, customer care, purchasing, sales and marketing, land development, land acquisition, and accounting staffs. ————————————————-
Redundancy : Assigning more people to a task than necessary The lag between acquisition of the land and sale of the final house built was three- five years. Reduce the business cycle
The homes will be built in two formats: a triplex townhome and a six- plex cluster home, but the format had not been previously offered in Southern California. The residents of Southern California may not accept these kinds of formats. Harry and Michael want to lower the required IRR or to raise the projected IRR to ensure that the project would be approved. Personnel controls：have a conscience that leads them to do what is right find self-satisfaction when they do a good job and see their organization succeed
Ethics and morality
RBH builds single-family and higher-density homes, such as townhouses and condominiums. RBH often had to make significant price concessions and construction costs were continuing to rise. The stock price had declined almost 50% from the all-time peak in 2005. Because the homebuilding started slowdown in early 2006, so finances were expected to be much tighter in 2007. Harry, the president resisted the idea of downsizing of the division in 2007 and wanted to keep employee team intact.
RBH spends considerable effort in preparing formal land acquisition proposal, which examines the proposed building project from housing development type, construction challenges and costs, marketing prospects, and environmental concern. The Platinum Pointe deal is a large one that would bring in considerable revenue and profits in the 2008-2011 time periods.
1. Modification of risk rating procedure
RBH’s procedure requires the identification of risk in four areas: political, development, market, and financial. The risk of each project in each of these four areas must be rated as low, moderate or high. The higher a project’s IRR, the more desirable it is to undertake the project. Michael was disappointed about the Platinum Point site project because the IRR was only 21%, while the minimum required IRR for a project of this risk should be 24.5% (3.5% variance).
The problem of existing risk rating procedure?
How to assess the risk rating? By who?
2. Joint venture with other homebuilding company
Advantages and disadvantages
3. Ethical problem- Harry contemplates preparing projects that were a little too optimistic to ensure that the project would be approved. Harry tries to disclose the degree of optimism in the forecasts or acting in a less than honest way. If Harry doing so, who will be harmed or put at risk?
Due to decreasing margins on their recent construction projects RBH needs a project to bring their revenues and profits up for the upcoming years. RBH’s Southern California division (one of 15) and its VP Michael Borland have come up with a prospective project “The Platinum Pointe Land Deal” which has potentials to increase profits and revenues. The issue with it remains is that the project has a IRR of 21 and for a project like this Michael Borland and his division has calculated a required IRR of 24.5. Possible ways to remedy this specific issue can be as follows:
Increase IRR of “The Platinum Pointe Land Deal”:
1. Since the recent environment factors are forcing of margins to decline RBH may need to adapt to this situation just to have this “The Platinum Pointe Land Deal” approved. One factor identified out of the assumptions in Exhibit 3 – Purchasing Section is to allow more profit participation for the seller Jackson Development company. Currently set up as 50% share above a net 9% profit for the project. Giving the Jackson Development company a share of 52-54% above the 9% net profit will increase the “The Platinum Pointe Land Deal” overall IRR from 21% to closer to the required 24.5% (how by giving up profit will their IRR increase?) 2. Although the Southern California division is large for RBH but their overall exposure and knowledge in the area can be limited. For example, the market demand for the house structures (condo’s.
Detached, semi-detached etc.) or even the market demand for amenities included (backyards, parks, garages, driveways etc..) is all the information that a local company native of Southern California will have better information of and RBH is disadvantaged to that. So the solution here is to consider a Merger and Acquisitions approach to hedge this information risk and to also expand the company as a whole. The project is large enough to justify such as move for RBH. This in fact will increase the 3 factor of IRR calculations the “Market” seen in Exhibit 3. As a result the “The Platinum Pointe Land Deal” IRR will increase bringing it closer the required 24.5%.