Question

Charles and Caitlin 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 operating cash flows for this project (call it Project A) as follows:

PROJECT A                                                                                                 

YEAR	0	1	2	3	4
Expected CFs ($)	-1,000,000	50,000	200,000	600,000	1,000,000

An alternative to pursuing this project would be to sell their innovative chip design to one of the established chip makers. This way, they would receive an upfront payment. But the amount would be relatively small – perhaps around $200,000 – 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. Dave and Eva 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 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, Charles and Caitlin were pretty sure that there would be sizable profits in the first year. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry.

Keeping this in mind, they estimate the future cash inflows for this project (call it Project B) as follows:

PROJECT B                                                                                                 

YEAR	0	1	2	3	4
Expected CFs ($)	-900,000	650,000	650,000	550,000	300,000

Charles and Caitlin 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.

One of the concerns that Charles and Caitlin have is regarding the reliability of their cash flow estimates. The analysis depends on the accuracy of those projected cash flows. However, they are both aware that actual future cash flows may be higher or lower.

QUESTION   

1. Which of these projects would you recommend? Explain why.

Answer 1

1]

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period for A = 3 + ($150,000 / $1,000,000) = 3.15 years

Discounted Payback period is the time taken for the cumulative discounted cash flows to equal zero

Discounted cash flow = cash flow / (1 + required return)^year

Discounted Payback period for A = 3 + ($472,222 / $482,253) = 3.98 years

NPV is the sum of the discounted cash flows.

NPV of A = $10,031

IRR is calculated using IRR functions in Excel

IRR of A is 20.37%

PI = (NPV + initial investment / initial investment)

PI of A = (10,031 + 1,000,0000) / 1,000,000 = 1.01

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period for B = 1 + ($250,000 / $650,000) = 1.38 years

Discounted Payback period is the time taken for the cumulative discounted cash flows to equal zero

Discounted cash flow = cash flow / (1 + required return)^year

Discounted Payback period for B = 1 + ($358,333 / $451,389) = 1.79 years

NPV is the sum of the discounted cash flows.

NPV of B = $556,019

IRR is calculated using IRR functions in Excel

IRR of B is 54.01%

PI = (NPV + initial investment / initial investment)

PI of A = (556,019 + 900,0000) / 900,000 = 1.62

Project B is ranked higher than Project A on NPV, IRR , payback period, discounted payback period and PI

Project B is recommended as it ranked higher than Project A for every measure