— 2 —

A NEW SHIRT

It was 6 a.m., the morning after my first day at HGS. I had finally returned to my hotel room at 2 a.m. A few ten-minute increments of extra sleep won out over my commitment to morning exercise. Now, I was up, getting ready to continue the work from last night—I mean, from this morning. I also needed to be ready for my first interview, with Shirley Rickert, HGS’s CFO, later that afternoon. But right now what I needed most was coffee—black and strong. It was already brewing on the hotel credenza, thanks to the coffee essentials provided to guests.

Work on the HGS project had begun almost as soon as our meeting with the top management team ended. Darla Hood showed Vivek, Gordon, and me to the team room on the seventieth floor. While we organized the room—three computers, a couple of bookshelves, a phone line for conference calls—Darla brought us our IDs.

The physical work of organizing our workspace was surprisingly relaxing, especially after the morning meetings. It also gave Gordon, Vivek, and me time to reflect on what we’d heard.

Gordon was confident. “I’m not surprised by the offer. Someone was bound to notice. The company’s stock is trading within sight of its five-year low; its top management team isn’t moving to market with its new technology. I suspect there are other opportunities languishing around here as well.”

“But why a private equity firm?” Vivek wondered. “If HGS isn’t realizing the potential of a new chemical technology, wouldn’t a strategic acquirer—like another specialty chemical company—be the logical choice?”

“Who knows?” Gordon answered. “As Carl mentioned, other firms may also be interested. But private equity does like firms with unexploited technologies. They can sell or license these real fast, pay themselves a dividend, and rapidly recoup their investment.”

“Is this going to change the nature of our work?” I asked.

“Probably not,” replied Gordon. “Really, our task and the interests of the private equity firm are aligned here—we both want to find the highest-value uses of this Plastiwear stuff. We might have different time horizons—they probably want this done yesterday. But besides that, our efforts are consistent.”

“Maybe we can call their team and get their analyses,” I joked. “Save us some time, for sure.”

Gordon grimaced so I quickly shifted back to no-nonsense mode: “There is another big difference. If HGS implements a Plastiwear strategy, Carl and his top management team will still be here. If the private equity firm does, there’s a good chance that many of the managers we met with this morning won’t have jobs at HGS anymore.”

We were just about done setting up the team room when there was a knock on the door.

“Hello, anyone there?”

“Yes, yes, come in,” Vivek responded and moved quickly to open the door.

On the other side of the door was a man in his early fifties, about five feet eight inches tall, stocky, with unruly salt-and-pepper hair. He wore baggy gray pants, a worn blue blazer, a blue button-down shirt, and a red tie, not entirely tightened up around his neck. My first impression was that this was a guy who doesn’t care how he looks—or maybe, a guy who doesn’t have to. His ensemble—if it could be called that—was completed with black shoes that likely hadn’t been polished since they were purchased.

“Hi, I’m Bill Dixon. Carl asked me to come down and visit with you folks.”

Bill entered the room with his hand extended and a smile on his face. Vivek was closest and introduced himself.

“Hello, I am Vivek Chatterjee. And these are my colleagues Justin Campbell and Gordon Lee.”

Bill turned to Vivek, quickly withdrew his hand from the handshake, brought the palms of his hands together, and bowed slightly.

“Namaskar.”

Vivek did the same and responded, “Namaskar.”

Bill’s greeting to Gordon and me was more conventional. “And Mr. Campbell, Mr. Lee, it’s a pleasure to meet you as well.” His handshake was warm and friendly.

Bill looked around at the team room. “Well, you folks are getting right to work, aren’t you? Not the most attractive conference room in the building, but it will meet our needs. So, what’s on your agenda for the rest of the day?”

I pulled over a chair, but Bill didn’t sit down.

Gordon explained that our first task was to finish analyzing the work that HGS had already done on Plastiwear and the shirt industry, along with some material we dug up on the men’s apparel industry. We were just about to divide these reports into two piles—one for me and one for Vivek—when Bill arrived.

“Excellent,” was Bill’s comment. “I’m familiar with most of these reports already, but it’ll be good to get an independent read from you. I have some prior commitments that will keep me busy today, but I’ll be able to give you more time after that.”

“Well, our work plan draft is out the window since the deadline changed,” Gordon explained. “Carl told us about the situation with MG Management this morning.” Bill nodded and Gordon continued, “Justin and I are scheduled to interview Shirley Rickert and Scott Beckett tomorrow. You and Vivek, assuming you’re available, have meetings scheduled with some corporate marketing people starting tomorrow afternoon.”

Bill pulled out his BlackBerry and looked at his schedule. “Why don’t you e-mail me a new cut at the work plan and schedule, including any other interviews you’ve planned. I’ll respond with my suggestions.”

“Of course. Sounds great,” Gordon replied. “I assume you’ll work in your own office, but we’re hoping you spend enough time here with us so that we can benefit from your experience.” Bill put his BlackBerry back in his pocket and looked around the room. After what seemed like a long silence, he smiled again. “Excellent. Well, gentlemen, this should be fun. Here is my card, with all my contact numbers and my e-mail. Vivek, I will meet you, where—here?—tomorrow at what time?”

“How about noon? Then we can get a quick lunch and go to our interviews.”

“Excellent. OK, gentlemen, I’ll see you later. I’m looking forward to this effort.”

And with that, Bill Dixon—our man on the inside—was gone.

I wanted to talk to the others about Bill’s role on the team, but Gordon needed to leave. After a quick huddle about our highest priorities, Gordon was gone, and Vivek and I withdrew into our thicket of paper and files.

________________

That was yesterday afternoon. And ever since, I’d been reading and summarizing HGS reports. I’ll say this about HGS—they didn’t spare any trees when it came to evaluating Plastiwear. My high-priority reading stack alone was over ten inches tall—mostly double-sided—and new e-mails with files attached were coming in from Livia every few minutes! Lots of analysis and still no final decision. Was this a classic case of paralysis by analysis—where managers keep cranking numbers to avoid making a decision? If so, what were these guys afraid of? Or maybe it wasn’t fear, but lack of motivation or incorrect incentives? Suddenly I wished I had paid more attention in my OB class.

I found the technical backup for HGS’s patent application interesting. It emphasized Plastiwear’s unique chemical structure and the valuable properties of Plastiwear fiber and fabric. The patent office agreed that Plastiwear was an original invention and granted HGS a patent in due course. The remaining reports evaluated the market potential of Plastiwear in a variety of markets, although most of this work focused on men’s white dress shirts.

I thought about my own shirts as I waited for the coffee to perk. I had brought three on this trip—two white and one blue. I had originally expected to go home after a couple of days, but our new schedule made that impossible. I sent two of the shirts to the cleaners last night and so found myself, this morning, wearing my last clean shirt. It was important for me to look good today since I would be doing interviews with Gordon. It was bad enough to be the rookie, but I didn’t want to look like the rookie.

It seemed to take forever, but the coffee was finally ready. Now I could get started on my work. I eagerly grabbed my cup and sipped. It was hot, but the deep familiar flavor was comforting. I also knew that the caffeine I was ingesting would give me the kick I needed.

Walking back to my computer, I guess I was paying more attention to drinking than walking. My right foot hit the corner of the bed and I stumbled. Catching my balance, I avoided falling, but splashed scalding hot coffee on the desk, my laptop, and all over me. Putting my cup down, I quickly ran to the bathroom for towels to soak up the spilled coffee. Most of the reports escaped serious damage, and I managed to dry off the computer before it short-circuited.

Only then did I look at my shirt. My last clean shirt. There, on the front right panel, was a coffee stain. Roughly three inches in diameter. The fact that it was shaped like the state of Texas wasn’t the least bit comforting. Quickly taking my shirt off, I laid it on the bed and ran to the bathroom for a washcloth and soap. Maybe I could get the stain out before it set. Three minutes of scrubbing made it clear—Texas was not going away. I could hear the jokes already.

So, here I was. My first client interviews, with coffee spilled all over my shirt, and no others in the closet. What were my options?

Option one—maybe no one would notice. One more look at the shirt dashed that hope.

Option two—cleaners. Quickly, I called the concierge. After just a few rings, a voice answered.

“Good morning, Mr. Campbell, this is the concierge. How can I help you?”

“Good morning. Listen, I need to have a shirt cleaned—quickly. It has a coffee stain and I need it today.”

“I will be happy to send someone up to collect your shirt and we can get it cleaned. We can have it back to you by three this afternoon.”

“Three o’clock? I have a meeting at one; three o’clock won’t do.”

“I’m sorry, sir.”

“Do you have other suggestions?”

“Well, sir, you could purchase a shirt.”

“Yes, good. Are there any men’s clothing stores around here?”

“Yes, sir, several.” The concierge then ticked off several men’s stores within a short distance of the hotel. “I can provide directions, if needed. Of course, sir, none of these stores open before ten.”

“Well, I can work here until they open.”

“Very well, sir. Anything else I can help you with?”

“No, thank you.” Maybe this would work out OK. Rather than going to the team room early this morning, I would just work in my room until 9:45 and then go buy a shirt. I would wear the new shirt, give the old one to the concierge to be cleaned, and everything would be fine. On second thought, maybe I better get two new shirts, just in case there is a problem with the cleaning.

I pulled on the coffee-stained shirt, threw my wet towels into the tub, and got things arranged at the desk so I could get to work. And then it struck me, like a bolt of lightning: I had never bought a new white dress shirt before.

I know. It’s a little embarrassing. Here I am, twenty-seven years old, a highly educated, sophisticated business professional, staying in a fancy hotel, getting paid the big bucks, and I’d never bought a dress shirt before.

Now, don’t get me wrong; I’ve bought plenty of shirts. T-shirts. With several different slogans—you know, “Hook ’em Horns” and “Aggies Go Home.” Even a couple of nice polo shirts with the dead alligators on the front, and some casual button-downs—“business casual” was the standard dress at my old job. But I had never bought dress shirts like those I needed now.

My mom had been the shopper. My whole life. She did the same for my father and my brothers as well. Recently, my girlfriend Jackie bought me a blue dress shirt—one of the shirts I had brought with me on this trip, in fact. But, so far, I had never purchased a white dress shirt for myself. And truthfully, I had no idea where to start. What makes a “good white shirt” good?

It was too early to call my mom, and I wasn’t really sure Jackie knew that much about buying shirts. For sure, none of us had ever purchased $400 shirts, like Ken’s.

A few minutes on the Internet left me amazed by what I didn’t know about buying shirts. One Web site that specialized in customized dress shirts listed all the choices I would have to make if I bought one from them: fifteen types of collars—everything from “classic straight” to “English wide spread” to “narrow contour”; nine types of cuffs—one-button and two-button, rounded corners, square corners, French cuffs; four kinds of pockets; four types of pleats on the back—plain, inverted, side, and box; and four different fronts. And this didn’t include fabrics. Or colors. Or patterns.

In choosing fabrics, several factors needed to be considered—one- versus two-ply, fabric weave, thread count, yarn size, and length of cotton. I had no idea what any of this stuff meant. It turns out that one- or two-ply refers to whether a fabric is woven with a single fiber (one-ply) or two fibers twisted together (two-ply). As far as I could tell, two-ply fabrics are smoother and stronger than one-ply fabrics. In terms of weave, the Web site described poplin, broadcloth, twill, herringbone chevron twill, chambray, royal oxford, pinpoint, and dobby. From what the site said, it seemed likely that a pinpoint weave would give me the most classic look. Thread counts—the number of threads per inch, I suppose—vary dramatically and apparently determine what I would describe as the density of a fabric, how thick it is. Lower-quality shirts have thread counts in the 50s to the 80s. Good shirts are in the 100 to 110 range. The best shirts—or at least the most expensive—have thread counts from 120 through 160.

And then there was the cotton. Yarn size measures the thinness of the cotton—something to do with the number of hanks (840 yards) in a pound of cotton. Low-quality cotton—like the stuff in blue jeans—has a yarn count in the teens, while the best cotton fabric has a yarn count in the 200s. Finally, the length of the cotton refers to how long the cotton ball is before it is harvested. The longer the length—this type of cotton is called extra-long staple or ELS cotton—the smoother and softer the fabric. The three ELS cottons generally available seemed to be Egyptian, Seal Island, and pima.

So, based on my online crash course, I decided that I needed to buy a white shirt with a traditional spread collar, two-button cuff with square corners, rounded pocket, box pleat back, plain front, made out of pinpoint two-ply fabric with a thread count greater than 110, a yarn count near 200 or so, made out of ELS cotton. Oh, yes, and I wanted it to fit. I worked on summarizing more of the HGS documents until it was almost ten o’clock, and then set out on my shirt-buying mission.

My first stop was a well-known men’s clothing store, one with over a thousand shops in the United States. Growing up, this was the fanciest men’s clothing brand I knew, so I thought it would be a good place to start. It looked like I was the first customer of the morning.

“Good morning. May I help you?” asked one of the two salesmen in the store. The salesman looked resplendent, decked out in a suit and tie that, I presumed, were from this very store. The suit was gray flannel, the shirt white, the tie a sea-green pattern.

“Well, as you can see, I need a new shirt.” I pointed to the coffee stain.

“Yes, I can see we’ll have to find you something immediately. Why don’t you look around while I get the measuring tape.”

He directed me to a wall of shirts—white, blue, French blue, some patterns, but mostly solids. After just a few seconds, he was back at my side.

“By the way, my name is Jay. Jay Palermo.” He reached out his hand to shake mine.

“Nice to meet you. I’m Justin Campbell.”

“In town for business, Mr. Campbell?”

I nodded. “I’ll be here the next week or two, I guess. Didn’t realize the trip would be so long, so I’ll probably need more shirts than I planned on.”

“Well, we have many excellent shirts to choose from. Here, let me measure you.”

The measuring process was thorough—around the neck, chest, and waist, from the top of the shoulder to the wrist.

“Obviously, since you are going to have to buy an off-the-shelf shirt today, some of these measurements are unnecessary. But if you ever decide to special-order some shirts, we’ll have them on file at all our stores around the world.”

“Thanks.”

“So, tell me, what kind of shirt were you thinking of?”

“Well, I would like a white shirt …” I paused as I pulled out the list of criteria I had written down earlier. “I would like a two-ply pinpoint all-cotton shirt with a thread count of at least 110, made with cotton with a 200-yarn count, and, if possible, made with Egyptian, Sea Island, or pima cotton.”

“I see you’ve done your homework.”

“That’s what the Internet is for,” I replied with some pride.

“Yes, indeed,” he agreed, although I had a sense that Mr. Palermo had forgotten more about dress shirts than I would ever know. “Let me show you what we can do today. First, to get the thread count and cotton type you are requesting, you would have to special-order your shirt.”

“How long would that take?”

“About five to six weeks.”

“Maybe later.” I tried to smile.

“Indeed. But this is what I have in our ready-made line.” He held out a white shirt for my consideration. “Thread count of 80, two-ply pinpoint, made with Supima cotton—not as silky as the ELS cottons you requested, but a very good fabric. This particular shirt has a traditional spread collar, a two-button square-cut cuff, a rounded pocket, box pleat in the back, and plain front.”

“What would the 120 thread count fabric look like?”

“Here, let me show you.” The salesman put down the shirt he had been showing me and brought me to a table where several small books about the size of CDs were stacked. He searched through the stack briefly and pulled out one of the books. Opening the book, he explained, “Here are examples of the fabric you described to me. This particular fabric”—he pointed to one of the samples in the book—“is made out of Egyptian cotton, a thread count of 140, two-ply, of course, pinpoint. Go ahead and see how you like it.”

I touched—no, I caressed the fabric in the book. It was noticeably softer than the 80 thread count shirt I could buy today. “Boy, that is nice. I didn’t really know there was this much difference between fabrics.”

“Yes, this is beautiful, isn’t it? A custom-made shirt with this fabric would last you for years.”

“How much would that cost?”

“That is our top-of-the-line shirt. It would cost you $387, plus tax.”

I had discovered a $400 shirt!

“Well … maybe in the future I’ll be ordering some of these. In the meantime … ” I looked back over to the ready-made shirt rack.

“Very well, sir. How many would you like?”

“I think two.”

“Fine. That will be $174 plus tax.”

As we went back over to the counter to pay for what now felt like completely inadequate—although still pretty expensive—shirts, my mind went back to breakfast, just yesterday, when Ken had favorably compared his Plastiwear shirt to one of his $400 shirts. As I charged my ready-made shirts, I couldn’t help but wonder if it would really be possible to buy a shirt that felt and looked like a $400 shirt off the rack for $60, custom-made for $150.

If Plastiwear felt and wore as well as that top-end shirt, one thing was completely clear—I wanted to buy a Plastiwear shirt. In fact, I wanted to invest in Plastiwear!

________________

After seventeen hours reading reports about Plastiwear and shirts, I was really looking forward to my first meeting with a living breathing HGS manager. Gordon and I were scheduled to interview Shirley Rickert this afternoon.

I was hoping Shirley would help me solve a mystery. Six of the reports I read had calculated the present value of the cash flows that Plastiwear white shirts would generate—just like I learned to do in business school. And as far as I could tell, each of these calculations was done correctly—they all projected cash flow net of investment and discounted it back to the present. And yet, these six reports generated different results. And not small differences: two concluded that this opportunity would generate almost $1 billion in present value; two concluded it would destroy almost $1 billion in present value; and two concluded it would about break even for HGS—a positive present value of $100,000 for one of the reports, a negative present value of $60,000 for the other.

This wasn’t supposed to happen. What I’d learned in school was that careful application of principles from finance would create a clear picture of a project’s future cash flows, which then could be appropriately discounted. Some small differences in analyses might emerge—but the $2 billion swing in these reports was way beyond the variance I expected, especially since this wasn’t exactly a high-tech venture or volatile industry being analyzed.

I’d spent several hours listing differences among these calculations, trying to understand why they’d generated such wildly different conclusions. One clear difference had to do with their projected cash flows. The optimistic calculations estimated that building a Plastiwear plant would cost less than $3.5 million. It looked like these two calculations assumed that some excess capacity in the packaging division could be redeployed to begin making Plastiwear. The pessimistic calculations estimated a cost of over $28 million to build a new plant, including $3 million for environmental protection. Also, the optimistic calculations relied primarily on trade and word-of-mouth advertising to build sales for the new shirts; the pessimistic calculations included advertising and marketing expenses starting at $20 million in the first year and rising to $35 million in year five, at which time they would decrease to $30 million per year, increasing with inflation thereafter. The breakeven reports used cash flow projections midway between these extremes. Even the discount rates these reports used varied. The optimistic calculations used a discount rate of 7.5 percent, equal to HGS’s weighted average cost of capital—that is, how much it cost HGS to borrow money and the rate of return it had to promise its investors in order to attract equity investment, weighted by how much debt and equity HGS had. The pessimistic calculations used a discount rate of 24.5 percent and 26 percent, respectively. Again, the breakeven projections used a discount rate that fell between these two extremes—14 percent for one and 15 percent for the other.

Now, one interpretation of this maze of calculations was that HGS had just done a standard sensitivity analysis. With sensitivity analysis, the idea is to try to understand the range of outcomes that an investment might generate. At a minimum, you calculate an optimistic outcome, a middle-of-the-road outcome, and a pessimistic outcome.

Sensitivity analyses—even the simple ones—can give decision makers information about possible outcomes before they make an investment decision. For example, if everything goes right with this investment, will it transform the company? Does it have enough upside potential to create real economic value for the shareholders? And, alternatively, if everything goes wrong with this investment, will it destroy the firm? How much risk is the firm assuming by green-lighting a proposed project?

So, having six different analyses generate a variety of outcomes, ranging from optimistic to pessimistic, by itself, was not a surprise. What surprised me was that these calculations had been done independently of one another—not as part of a larger sensitivity analysis. The guys who generated the optimistic calculations supported the numbers they generated. In fact, one of the optimistic reports included its own sensitivity analysis and concluded that its conservative projection—adding $1 billion of present value to HGS—was the most realistic. In the same way, both of the pessimistic reports included their own sensitivity analyses—one reported as the most reasonable projection the “middle-of-the-road” estimate, the other highlighted the pessimistic estimate.

So, these multiple projections were not the result of a single analyst carefully evaluating the range of possible outcomes associated with this investment; they were the result of six separate analyses, each coming to different conclusions.

I had jotted down some questions to discuss with Gordon, but based on my reading of these reports, I was really looking forward to meeting with Shirley. If anyone could help us to make sense of this mess, it would have to be the CFO. I had agreed to meet Gordon in the team room around noon. I arrived a couple of minutes early. It was empty. No problem. I began to organize my thoughts and ran through some calculations, cross-checking the figures in the reports. A few minutes after twelve, my cell phone rang.

“Hello, Justin Campbell.”

“Hi, Justin. It’s Gordon. Listen, I’m not going to be able to break away from here for those interviews this afternoon.”

“You’re not?”

“No. Listen, I’m very sorry about this, but as I mentioned yesterday, this project I’ve been working on has taken an unexpected turn. I wish I could get someone else to do the work, but I’m really the only one in a position to keep this thing together for this client. So, go ahead with the first interviews.” Gordon paused, and I thought I could hear someone talking to him before he continued. “We could reschedule, but given the time crunch we’re in at HGS, you should just go ahead.”

“These will be the first interviews I’ve done on this job.” I hoped I didn’t sound desperate, just truthful.

“Yes, but after getting close to the material, you’re in a better position now than I am to do today’s interviews. Besides, Ken and Livia both agree, right now there really aren’t any other options. Vivek and—what’s his name—Bill Dixon, are already at lunch and are scheduled to meet with the marketing folks this afternoon.” Gordon took a short breath. “So, you OK with this?”

“Well, I guess if you all agreed already, I’ll do the best I can.”

“I’m sure you’ll do fine.” Gordon sounded more rushed than reassuring. “You can get me up to speed later. Make sure you send me your notes. Listen, I’ve got to run now. I’ll talk to you later.”

“Bye.” And with that, Gordon hung up.

Truthfully, part of me was glad that Gordon wasn’t going to be there this afternoon. With Gordon at the interviews, I would be the junior partner—take notes, get coffee, smile at the appropriate times—the Vanna White of the team. Now, these were going to be my interviews. If I was lucky, maybe I would crack this case this afternoon. That would start my career at the firm off with a bang. And the truth is—I thought I was up for the challenge. After all my reading, I thought that I knew enough to ask some pretty good questions.

So, that’s how I came to be ushered into the CFO’s office—wearing my newly purchased white shirt—at 1:00, alone. Shirley’s secretary announced me.

“Justin Campbell here to see you, Ms. Rickert.”

I entered her office with my hand extended in what I hoped was a confident professional greeting.

“Ms. Rickert, good to see you again.”

“Please, Justin. Come in. And please, call me Shirley.”

She motioned for me to sit down on a small couch. She sat opposite, in a small chair covered in the same red fabric as the couch, a low black coffee table between us. A small flower arrangement that complemented the colors in the office sat on the table. The whole look was sophisticated, vaguely oriental, yet very comfortable.

“Would you like something to drink?”

“Yes, water would be nice.”

“Kathy,” Shirley called to the woman outside her door, “will you get the two of us some water?”

A woman I presumed was Kathy came into the room with two bottles of water and gave one to me and the other to Shirley. Our conversation began with some generic banter about business school—how her MBA had changed her life in ways she hadn’t anticipated. I took the opportunity to really look at Shirley for the first time. She looked younger than I remembered from our first meeting, with light brown hair parted on the side, just covering her ears. She was wearing black pants and a black jacket. A string of pearls and pearl earrings were her only jewelry. Her conversational style was at once warm and reserved, professional yet cautious. After a few minutes, she checked her watch. “So, will Mr. Lee be joining us?”

“I’m afraid he’s been called away on some emergency business.” I realized I should have led with this information and hurriedly explained, “He asked me to go ahead and conduct this interview without him.”

“Oh.” She paused just a tick. “So, how can I help you?”

“Well, I reviewed some impressive analysis on Plastiwear. And not just impressive in terms of volume—although I did measure my reading in inches, not pages.”

I thought I caught a smile flicker briefly across Shirley’s face. “At HGS we are nothing if not thorough. In fact, sometimes I think we are too thorough.”

I set that comment aside, thinking that I might come back to it later, and glanced at my notes. “I did have some questions about the present value analyses that have been done on Plastiwear and the shirt opportunity.”

“Bit contradictory, are they?” she asked, as if she already knew how confusing these analyses were.

“Well, at first, I thought that maybe they were defining the bounds of sensitivity analyses. But the more I read, the more it became clear that there is fundamental disagreement about the potential financial impact of Plastiwear on your firm.”

“I don’t think our disagreement could be any more fundamental.”

“So, how do you usually calculate present values at HGS?”

“Oh, our approach is pretty standard. For extensions of current product lines, we use our past experience to estimate what kind of investment will be required—you know, in plant and equipment, distribution, sales and marketing, and all the rest. Then, we go to our current customers to gauge their interest in this new product. This is a little tricky since it’s always hard to get an accurate estimate of ‘hypothetical sales.’ Actual sales tend to lag behind our customer survey estimates, but we factor that in, doing things like latent demand analysis where appropriate. Then, with cost and revenue estimates in place, we project cash flows and discount them back to the current period.”

“What discount rate do you use?”

“For product extensions, HGS’s cost of capital. Lately between 7 and 8 percent. Then, we do some sensitivity analysis, make sure we’re not going to break the company if things turn south on us, and discuss the results in our management meetings.”

“Sounds straightforward—like maybe the person who designed this got an MBA in finance from Wharton.”

“Oh no,” she said, shaking her head. “This process has been in place for at least ten years.”

“So, if HGS has been using this process for years, why so much variance for Plastiwear?” I hoped my impatience to get this question answered and move on with the rest of the interview wasn’t too obvious.

“Well, with many product extensions, these calculations are very useful. Some people think that Plastiwear is not a product extension—but more of a radical new technology.”

“Can’t you apply NPV logic for even radical technologies?” I asked.

“Well, to get present value, you need cash flows and discount rates, right?”

“Right.”

“For radical new products, cash flows are often tricky to estimate.”

“Can’t you ask customers about their interest?” I continued.

“That’s hard to do when customers don’t really have a clear idea about the new technology. Our own scientists don’t even have a very good idea about Plastiwear’s real potential. And besides, that’s only on the revenue side. Estimating the cost of exploiting this technology also requires making sense of ambiguous and incomplete information.”

“So it’s hard to get good estimates of future cash flows based on questionable revenue and cost estimates. But what about discount rates—there was such a spread in the reports …”

“The cost of capital is the opportunity cost of investing in product extensions, and that’s the right discount rate,” Shirley continued. “If we don’t invest in this business, we could invest in our other businesses and earn at least this level of return. But when it comes to Plastiwear, should we use the rate for an extension of our current businesses or the much higher rate for an entirely new business? As you’ve seen, there are arguments that cut both ways.”

“What I was taught is that you should choose a discount rate that reflects the riskiness of the cash flows associated with this investment, not the firm’s cost of capital,” I added.

“That’s right. But, here’s the problem. For a really radical innovation, we don’t know, for sure, just how risky that cash flow is. If you don’t know how risky an investment is, how can you choose an appropriate discount rate?”

“Isn’t this where sensitivity analyses come into play—calculating NPV with different cash flow projections and different discount rates?”

“Justin,” like a professor losing patience with a slow student, Shirley spoke slowly and carefully, “those kinds of analyses—all they do is quantify your ignorance. They don’t tell you which cash flow is accurate and how risky an investment is; they tell you that different combinations of cash flow and risk will generate different NPV outcomes.”

“You mean, if different analyses adopt different assumptions, they have to generate different conclusions.”

“That’s right, Justin.” I flashed back to my MBA class.

“So, at HGS, how do you estimate projected cash flows and the discount rate, if the investment is really radical and new?”

“The thing to remember is that present value techniques—even when you are evaluating relatively straightforward investments—are just a way of keeping track of the financial implications of a strategy. NPV is one way we keep score in the game, but it’s not the game. NPV is no substitute for having a strategy.”

“So, the different numbers that were generated in the reports reflect different strategic analyses?”

“Maybe.” Shirley glanced at her BlackBerry and clicked off a reminder. “Maybe the optimists see Plastiwear as an extension of our current businesses.”

“Those reports did talk up the advantages of using some excess manufacturing capacity in the packaging division. That sounds like a product extension move.”

“Right. And the pessimists all assumed that we would have to build a new plant, deal with attendant environmental issues, and so forth.”

“But which of these assumptions about Plastiwear strategy is right?” Now I felt like a frustrated student whose professor won’t answer a question.

She looked mildly amused. “Wait. There’s something else you must realize about NPV. Sometimes, it can be a powerful tool for objective strategic analysis, but managerial biases can be baked into the analysis—often unintentionally.”

“What do you mean?”

“Well, who generated the optimistic present values?”

“Let’s see.” I quickly flipped through my notes. “The optimistic reports were produced by … a team reporting to Walter Albright—vice president of research and development—headed up by his assistant, Jerry Tucker …”

Shirley cut in with a wry smile, “Aren’t these the people in HGS most directly responsible for the invention of Plastiwear?”

“And the other optimistic report was produced by a team reporting to Robert Hutchins, the leader of the packaging division …”

“And the manager in HGS with excess manufacturing capacity that could be put to use to make Plastiwear. Now, Justin, where did the pessimistic reports come from?”

“They both were written by teams reporting to Scott Beckett …”

“Yes, the VP of oil and gas. You might expect that he sees Plastiwear as a distraction. You’d also be right if you assumed that any significant capital investment in Plastiwear would likely reduce capital spent on expanding his division.”

“So, what you are saying is that these calculations really just mask the personal interests of managers inside HGS?”

“No, I’m not saying that. I am saying this could be the case. It might also be the case that each of these teams came to its conclusions by evaluating Plastiwear in purely strategic terms. I don’t know which of these explanations, or maybe some other explanation, is true.”

“Where did the two middle-of-the-road reports come from?”

“They were generated by my office. To ensure the Plastiwear conversation wasn’t dominated by the extremes, I directed a couple of teams to show how Plastiwear would only break even.”

“Thus ensuring that all three points of view would be included in the conversation.” I nodded in agreement.

“Hopefully. Part of my job as CFO is to ‘direct traffic’ in these debates, to make sure that all relevant points of view are considered.”

“So, you’ve seen all the background material, including the analyses you helped build. You know the industry and these people. So, on balance, which NPV do you believe?”

Shirley paused before answering. After what seemed an eternity, she squared herself and looked right into my eyes.

“Well, Justin, that is an excellent question. The truth is—I don’t know. And more importantly, I don’t think it matters.”

At that moment, Kathy was at the door.

“Ms. Rickert, your next meeting is about to begin.”

“Thank you, Kathy.”

Turning to me, Shirley explained, “Kathy always keeps me on schedule.”

She stood and extended her hand.

“Thank you, Justin, for spending this time with me. If you have any further questions, give me a call.”

And with that, Shirley was gone, before I could even formulate a last question for her. I found myself leaving the CFO’s office shaking my head in disbelief.

She didn’t know. The CFO—presumably the person in HGS who has the best information about the financial implications of Plastiwear—didn’t know which of these analyses was right. And, it didn’t matter to her that she didn’t know. What the heck was going on?

Suddenly, I had this uneasy feeling that much of what I had learned in finance, while not wrong, was largely irrelevant. Actually calculating present value was the easy part, mostly just arithmetic. The hard part was creating a tight logic for generating the projected cash flows and choosing the appropriate range of discount rates—especially when the project in question was radical in nature. And financial analysis really had very little to say about how this was done. Oh, it gave you guidance about what should and should not be included in calculating net cash flows, but was silent about the extent to which these factors were likely to be relevant for a particular project.

Worse yet, Shirley had raised the possibility that these apparently sophisticated analyses were fairly easily swayed by individual biases or corporate politics. Now, instead of being a reliable and tangible basis for choosing a strategy, NPV seemed to be no more than another means for managers to manipulate information to further their careers or protect their interests.

But worst of all, if Shirley—the CFO, the person in the best position to untangle these issues—didn’t know which present value analysis I should use, how could I?

1.   Based on Justin’s experience buying a shirt, does your enthusiasm for Plastiwear increase or decrease?

2.   Why doesn’t Shirley know which NPV analysis is right? Why does she say that it doesn’t matter?

3.   How interested and influential is Shirley in the Plastiwear decision?

4.   Do you agree with Justin that the Plastiwear engagement is actually a pretty simple problem?

5.   What other questions should Justin have asked Shirley?

6.   How should the strategy team leverage Bill?