Question

Katie Holmes and Sam Wilson are facing an important decision. After having discussed different financial scenarios into the wee hours of the morning, 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 invest about $3,750,000 on plant, equipment and working capital. 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	($3,750,000)
1	$300,000
2	$590,000
3	$1,280,000
4	$2,125,000
5	$3,230,000

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 $300,000 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.

Katie and Sam 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 $3,900,000. After taking into account the sale of their patent, the net investment would be $3,600,000. As for the future, Katie and Sam were reasonably 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	($3,600,000)
1	$2,210,000
2	$1,825,000
3	$705,000
4	$427,500
5	$240,000

Katie and Sam now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 16% for both projects. Ideally, they would prefer that the project they choose have a payback period of less than 4 years and a discounted payback period of less than 5 years.

Below are the results of the analysis they have carried out so far:

Metrics	Project A	Project B
Payback period (in years)	3.74	1.76
Discounted payback period (in years)	4.69	2.75
Net Present Value (NPV)	$478,592	$463,480
Internal Rate of Return (IRR)	19.77%	24.03%
Profitability Index	1.1276	1.1287
Modified Internal Rate of Return (MIRR)	18.82%	18.84%

One of the concerns that Katie and Sam 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 Katie and Sam have hired you as a consultant to help them make the decision. Please draft an official memo to them with your analysis and recommendations.

questions:

1. Briefly, summarize the key facts of the case and identify the problem being faced by our two budding entrepreneurs. In other words, what is the decision that they need to make?

An excellent paper will demonstrate the ability to construct a clear and insightful problem statement while identifying all underlying issues.

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. a) Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV, IRR, Profitability Index, and MIRR.

b) Katie believes that the best approach to make the decision is the NPV approach. However, Sam is not so sure that ignoring the other metrics is a good idea. Which of the approaches or metrics would you propose? In other words, would you prefer one or more of these approaches over the others? Explain why.

An excellent paper will include an evaluation of solutions containing thorough and insightful explanations, feasibility of solutions, and impacts of solutions.

4. a) Which of these projects would you recommend? Explain why.

b) Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend.

Answer 1

Katie Holmes and Sam Wilson are planning to start their own venture.

They find 2 Projects i.e. Project A & Project B.

They had carried out analysis of these project on the basis of the following metrics:

Metrics	Project A	Project B
Payback period (in years)	3.74	1.76
Discounted payback period (in years)	4.69	2.75
Net Present Value (NPV)	$478,592	$463,480
Internal Rate of Return (IRR)	19.77%	24.03%
Profitability Index	1.1276	1.1287
Modified Internal Rate of Return (MIRR)	18.82%	18.84%

One of the concerns that Katie and Sam have is regarding the reliability of their cash flow estimates. All the analysis in the table above is based on “expected” cash flows.

The decision they need to make :

1.Which Project to choose ?

2.Which metrics should more importance ?

3.Reliability of cash flow should accurate to the extent possible

Concerns regarding the reliability of cashflows can solved by using Risk Adjusted Appraisal Criteria such as certainty equivalent coefficient method, risk adjusted discount rate approach,maximum risk profile method etc.

a. Ranking of the projects based on follwing metrics:

Metrics	Project A	Project B
Payback period (in years)	2	1
Discounted payback period (in years)	2	1
Net Present Value (NPV)	1	2
Internal Rate of Return (IRR)	2	1
Profitability Index	2	1
Modified Internal Rate of Return (MIRR)	2	1

b. Why NPV is the best method

NET PRESENT VALUE VS. PAYBACK PERIOD (NPV VS. PBP)

Payback period calculates a period within which the initial investment of the project is recovered.

The criterion for acceptance or rejection is just a benchmark decided by the firm say 3 Years. If the PBP is less than or equal to 3 Years, the firm will accept the project and else will reject it. There are two major drawbacks with this technique –

1. It does not consider the cash flows after the PBP.
2. Ignores time value of money.

The second drawback is still covered a bit by an extended version of PBP which is commonly called as Discounted Payback Period. The only difference it makes is the cash flows used are discounted cash flows but it also does not consider the cash flows after PBP.

Net present value considers the time value of money and also takes care of all the cash flows till the end of life of the project.

NET PRESENT VALUE VS. INTERNAL RATE OF RETURN (NPV VS. IRR)

The internal rate of return (IRR) calculates a rate of return which is offered by the project irrespective of the required rate of return and any other thing. It also has certain disadvantages discussed below:

1. IRR does not understand economies of scale and ignores the dollar value of the project. It cannot differentiate between two projects with same IRR but vast difference between dollar returns. On the other hand, NPV talks in absolute terms and therefore this point is not missed.
2. IRR assumes discounting and reinvestment of cash flows at the same rate. If the IRR of a very good project is say 35%, it is practically not possible to invest money at this rate in the market. Whereas, NPV assumes a rate of borrowing as well as lending near to the market rates and not absolutely impractical.
3. IRR enters the problem of multiple IRR when we have more than one negative net cash flow and the equation is then satisfied with two values, therefore, have multiple IRRs. Such a problem does not exist with NPV.

a) Which of these projects would you recommend? Explain why.

Project A should be considered as it has a higher NPV as compared to Project B.

b) Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend.

Ans. The biggest disadvantage to the net present value method is that it requires some guesswork about the firm's cost of capital. Assuming a cost of capital that is too low will result in making suboptimal investments. Assuming a cost of capital that is too high will result in forgoing too many good investments.

I recommend to do Risk Adjusted Appraisal Criteria while using NPV Method.