Question

Instructions: The assignment is based on the mini case below. The instructions relating to the assignment are at the end of the case.

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.

Your submission should cover the following 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? (10 points)

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? (10 points)

An excellent paper will propose solutions that are sensitive to all the identified issues.

3. a) Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV, IRR, Profitability Index, and MIRR. (10 points)

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. (20 points)

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. (10 points)

b) Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend. (20 points)

An excellent paper will provide concise yet thorough action-oriented recommendations using appropriate subject-matter justifications related to the problem while addressing limitations of the solution and outlining recommended future analysis.

Answer 1

	Project	A	B
	Pay Back Period (years)	3.74	1.76
	Discounted Pay Back (years)	4.69	2.75
	NPV $	478592	463480
	IRR	19.77%	24.03%
	Profitability Index	1.1276	1.1287
	Modified IRR	18.82%	18.84%
1)	whenever an entrepreneur invest into a project the first and foremost criteria to recover the initial investment at earliest
	for this purpose the payback is calculated . Further scientific approach is to calculated discounted payback .
	Project A has longer Payback as Compared to Project B. Thus here, considering the market risk and technical risk into consideration,
	thus the before any market competition and or before the technology becomes obsolete the initial investment is recovered.
	not only this the other techniques of the capital budgeting shows that project B is better than project A.
	therefore Project B should be chosen
2)	Majorly 4 techniques are use d to make capital budgeting decision
	Pay Back Period (years)
	it refers to the period by which the project recovers it initial investments. Its basic method and does not consider the time value
	of investment and cash flow. Hence the better version of this is discounted pay back period.
	here both, pay back period and discounted payback period is better for project B
	Net Present Value
	Its the most preferred method while making decision as it take into consideration the time value of money and
	thus helps entrepreneur to project the net discounted cash flow from the project. Since the project is yet to come into
	existence the cashflow is based on certain assumptions wherein the time value of money is one of the most important factor.
	Project with Higher NPV is Preferred ..in this case Project A has higher NPV than Project B
	IRR
	Its the most complex method of capital budgeting.
	its a rate when present value of cash inflow equal to cash outflow.
	the project where IRR is greater than cost of project then that option is considered as viable
	Profitabilty Index
	Its a ratio between present value of discounted future cash inflow to cash outflow at investment stage.
	the project is considered better if the ratio is greater than 1.
	In the given case both the projects have Profitability Index of greater than 1. but comparatively Project B has better Profitabilty index
3 a)	Project	A	Rank	B	Rank
	Pay Back Period (years)	3.74	2	1.76	1
	Discounted Pay Back (years)	4.69	2	2.75	1
	NPV $	478592	1	463480	2
	IRR	19.77%	2	24.03%	1
	Profitability Index	1.1276	2	1.1287	1
	Modified IRR	18.82%	2	18.84%	1
	most of the criteria are majorly fulfilled by project B. Hence project B should be given acceptance
3 b)	as discussed in point 2 above regarding various methods of capital budgeting, its not NPV but the other parameter also should be considered
	while making the decision. From the Matrix given its clear that project A ranks marginally better than project B in NPV criteria.
	but as an entrepreneur one has to consider all pros and cons of project. The Project should be able to recover investment and generate profit
	in time value of money also should be considered.
	if we take weighted criteria then Project B weights better than Project A .
4 a)	Will select Project B as it fullfills majority of the criteria of the capital budgeting techniques.
4 b)	every technique has its own pros and cons.
	the project is yet to come into existence and get expose to market volatality , consumer preference, market competition, government polices and other unforeseen factors.
	hence time value of money and recovery of investment in this parlance is the basic aim of the investor and further to earn profit.
	since the project has many embedded motives only one technique can not be considered in isolation for decision making.
	hence the decision should be based on weighted ranking based on the parameters given in the matrix.