Question

3. Capital Budgeting Assignment Instructions: The assignment is based on the case below. The instructions relating to the assignment are at the end of the case. Dan and Susan are facing an important decision. After having discussed different financial scenarios, the two computer engineers felt it was time to finalize their cash flow projections and move to the next stage – decide which of two possible projects they should undertake. Both had a bachelor degree in engineering and had put in several years as maintenance engineers in a large chip manufacturing company. About six months ago, they were able to exercise their first stock options. That was when they decided to quit their safe, steady job and pursue their dreams of starting a venture of their own. In their spare time, almost as a hobby, they had been collaborating on some research into a new chip that could speed up certain specialized tasks by as much as 25%. At this point, the design of the chip was complete. While further experimentation might improve the performance of their design, any delay in entering the market now may prove to be costly, as one of the established players might introduce a similar product of their own. The duo knew that now was the time to act if at all. They estimated that they would need to spend about $1,000,000 on plant, equipment and supplies. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once the product had established a name for itself, the price could be raised. By the end of the fifth year, their product in its current form was likely to be obsolete. However, the innovative approach that they had devised and patented could be sold to a larger chip manufacturer for a decent sum. Accordingly, the two budding entrepreneurs estimated the cash flows for this project (call it Project A) as follows: Year Project A Expected Cash flows ($) 0 (1,000,000) 1 50,000 2 200,000 3 600,000 4 1,000,000 5 1,500,000 An alternative to pursuing this project would be to immediately sell the patent for their innovative chip design to one of the established chip makers. They estimated that they would receive around $200,000 for this. It would probably not be reasonable to expect much more as neither their product nor their innovative approach had a track record. They could then invest in some plant and equipment that would test silicon wafers for zircon content before the wafers were used to make chips. Too much zircon would affect the long-term performance of the chips. The task of checking the level of zircon was currently being performed by chip makers themselves. However, many of them, especially the smaller ones, did not have the capacity to permit 100% checking. Most tested only a sample of the wafers they received. Dan and Susan were confident that they could persuade at least some of the chip makers to outsource this function to them. By exclusively specializing in this task, their little company would be able to slash costs by more than half, and thus allow the chip manufacturers to go in for 100% quality check for roughly the same cost as what they were incurring for a partial quality check today. The life of this project too (call it project B) is expected to be only about five years. The initial investment for this project is estimated at $ 1,100,000. After taking into account the sale of their patent, the net investment would be $900,000. As for the future, Dan and Susan were pretty sure that there would be sizable profits in the first couple of years. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry. Keeping all this in mind, they estimate the cash flows for this project as follows: Year Project B Expected Cash flows ($) 0 ($900,000) 1 650,000 2 650,000 3 550,000 4 300,000 5 100,000 Dan and Susan now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 20% for both projects. Ideally, they would prefer that the project they choose have a payback period of less than 3.5 years and a discounted payback period of less than 4 years. Below are the results of the analysis they have carried out so far: Metrics Project A Project B Payback period (in years) 3.15 1.38 Discounted payback period (in years) 3.98 1.79 Net Present Value (NPV) $612,847 $596,206 Internal Rate of Return (IRR) 35.93% 55.07% Profitability Index 1.61 1.66 Please be sure to validate the results above. One of the concerns that Dan and Susan have is regarding the reliability of their cash flow estimates. All the analysis in the table above is based on “expected” cash flows. However, they are both aware that actual future cash flows may be higher or lower. Assignment: Suppose that Dan and Susan have hired you as a consultant to help them make the decision. Please draft an official 2 page memos to them with your analysis and recommendations. Your submission should cover the following questions: 1. Briefly, summarize the key facts of the assignment and identify the problem being faced by our two budding entrepreneurs. In other words, what is the decision that they need to make? 2. What are some approaches that can be used to solve this problem? What are some various criteria or metrics that can be used to help make this decision? 3. Rank the projects based on each of the following metrics: Payback period, discounted payback period, NPV, IRR, Profitability Index. 4. Choose which of these projects would you recommend? Justify the reasons.

Answer 1

		ANALYSIS OF PROJECT A
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required return=20%=0.2
		N=Year of Cash Flow
	N	Year	0	1	2	3	4	5
	A	Cash flow	($1,000,000)	$50,000	$200,000	$600,000	$1,000,000	$1,500,000
	B	Cumultive Cash Flow	($1,000,000)	($950,000)	($750,000)	($150,000)	$850,000	$2,350,000	SUM
	PV=A/(1.2^N)	Present value of Cash flow	$     (1,000,000)	$      41,667	$         138,889	$        347,222	$      482,253	$     602,816	$     612,847
	D	Cumulative Present value of Cash flow	$     (1,000,000)	$ (958,333)	$       (819,444)	$     (472,222)	$        10,031	$     612,847
	NPV	Sum of PV of Cash Flows	$           612,847
		PaybackPeriod=period in which cumulative cash flow=NIL	3.15	Years	(3+(150000/1000000)
		Discounted payback=Period in which cumultive PV of cash flow=NIL	3.98	Years	(1+(472222/482253)
		Profitability Index=(61287+1000000)/1000000	1.61
		Internal Rate of Return	35.93%	Using IRR function of the Cash Flow)
		SENSITIVITY ANALYSIS:
		IF CASH FLOW IS 20% LESS THAN PROJECTION
	N	Year	0	1	2	3	4	5
	A	Cash flow	($1,000,000)	$40,000	$160,000	$480,000	$800,000	$1,200,000
	B	Cumultive Cash Flow	($1,000,000)	($960,000)	($800,000)	($320,000)	$480,000	$1,680,000	SUM
	PV=A/(1.2^N)	Present value of Cash flow	$     (1,000,000)	$      33,333	$         111,111	$        277,778	$      385,802	$     482,253	$     290,278
	D	Cumulative Present value of Cash flow	$     (1,000,000)	$ (966,667)	$       (855,556)	$     (577,778)	$   (191,975)	$     290,278
	NPV	Sum of PV of Cash Flows	$           290,278
		PaybackPeriod=period in which cumulative cash flow=NIL	3.40	Years
		Discounted payback=Period in which cumultive PV of cash flow=NIL	4.40	Years
		Profitability Index(290278+1000000)/1000000	1.29
		Internal Rate of Return	28.17%	Using IRR function of the Cash Flow)
		ANALYSIS OF PROJECT B
	N	Year	0	1	2	3	4	5
	A	Cash flow	($900,000)	$650,000	$650,000	$550,000	$300,000	$100,000
	B	Cumultive Cash Flow	($900,000)	($250,000)	$400,000	$950,000	$1,250,000	$1,350,000	SUM
	PV=A/(1.2^N)	Present value of Cash flow	$         (900,000)	$   541,667	$         451,389	$        318,287	$      144,676	$        40,188	$     596,206
	D	Cumulative Present value of Cash flow	$         (900,000)	$ (358,333)	$            93,056	$        411,343	$      556,019	$     596,206
	NPV	Sum of PV of Cash Flows	$           596,206
		PaybackPeriod=period in which cumulative cash flow=NIL	1.38	Years	(1+(250000/650000)
		Discounted payback=Period in which cumultive PV of cash flow=NIL	1.79	Years	(1+(358333/451389)
		Profitability Index(596206+900000)/900000	1.66
		Internal Rate of Return	55.07%	Using IRR function of the Cash Flow)
		SENSITIVITY ANALYSIS:
		IF CASH FLOW IS 20% LESS THAN PROJECTION
	N	Year	0	1	2	3	4	5
	A	Cash flow	($900,000)	$520,000	$520,000	$440,000	$240,000	$80,000
	B	Cumultive Cash Flow	($900,000)	($380,000)	$140,000	$580,000	$820,000	$900,000	SUM
	PV=A/(1.2^N)	Present value of Cash flow	$         (900,000)	$   433,333	$         361,111	$        254,630	$      115,741	$        32,150	$     296,965
	D	Cumulative Present value of Cash flow	$         (900,000)	$ (466,667)	$       (105,556)	$        149,074	$      264,815	$     296,965
	NPV	Sum of PV of Cash Flows	$           296,965
		PaybackPeriod=period in which cumulative cash flow=NIL	1.73	Years
		Discounted payback=Period in which cumultive PV of cash flow=NIL	2.41	Years
		ProfitabilityIndex=(296965+900000)/900000=	1.33
		Internal Rate of Return	37.96%	Using IRR function of the Cash Flow)
		SUMMARY OF ANALYSIS
			PROJECT A	PROJECT B	Project A with 20% reduced cash flow	Project Bwith 20% reduced cash flow
		Net Present Value(NPV)	$           612,847	$   596,206	$         290,278	$        296,965
		InternalRate of Return(IRR	35.93%	55.07%	28.17%	37.96%
		Payback period in years	3.15	1.38	3.40	1.73
		Discounted Payback period in years	3.98	1.79	4.40	2.41
		Profitability Index(PI)	1.61	1.66	1.29	1.33
		REQUIREMENTS:
		InternalRate of Return,greater than	20%
		PaybackPeriod ,Less Than	3.5 years
		Discounted PaybackPeriod ,Less Than	4years
		Project B has higher IRR andLower NPV
		Both meet the Conditions of Paybackperiods
		If Cash flow is20% less than projected:
		Project B willhave higher NPV and IRR
		Project A will not meet requirement of discounted paybackperiod
		HENCE, PROJECT B IS RECOMMENDED