Question

Mini Case:

Samantha Groves and Harry Finch 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 spend about $1,250,000 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	(1,250,000)
1	75,000
2	218,750
3	535,000
4	775,000
5	775,000

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 $100,000 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.

Harry and Samantha 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 $ 1,150,000. After taking into account the sale of their patent, the net investment would be $1,050,000. As for the future, Samantha and Harry 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	(1,050,000)
1	650,000
2	500,000
3	226,250
4	137,500
5	62,500

Samantha and Harry now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 15% 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)	3.54	1.80
Discounted payback period (in years)	4.58	2.72
Net Present Value (NPV)	$160,816	$151,742
Internal Rate of Return (IRR)	18.90%	23.84%
Profitability Index	1.13	1.14
Modified Internal Rate of Return (MIRR)	17.82%	18.15%

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

Instructions:

Your submission should cover the following questions:

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?

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?

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) Samantha believes that the best approach to make the decision is the NPV approach. However, Harry 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.

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

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

I would recommend Project B due to the following reasons:

(i) Project B has a significantly shorter Discounted Payback Period. Among all the metrics calculated by Samantha and Harry (payback period, discounted payback period, NPV, IRR, Profitability Index and MIRR), I consider discounted payback period to be the most suitable metric in this case. As mentioned in the case, this industry is highly competitive with rapid obsolescence of existing products/technology. Therefore any project with larger cashflows in the earlier years should be preferred since the expected cashflows in later years may not even realize due to the technology becoming obsolete. The smaller the discounted payback period the sooner the project is expected to break even and turn profitable. I prefer discounted payback period over payback period because the latter does not take into account the the time value of cashflows and considers cashflows at different times as the same in calculating the payback period.

(ii) As mentioned in the case, Samantha and Harry have concerns about the reliability of cashflows is low. This means that reliability of later year projected cashflows is even low. Consequently, other metrics such as NPV, IRR, PI and MIRR can not be relied upon since they are highly sensitive to cashflows.

(iii) Project B lets Samantha and Harry monetize their patent right away thereby bringing in cash in hand ($100,000). In addition, Samantha and Harry are pretty confident of generating decent cashflows in the first few years of Project B. This contrasts with fuzzy projections of cashflows for project A with most of the payback happening in later years with very low certainty.

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

The limitation of using discounted payback period approach is that it may miss projects with very high cashflows late in project lifecycle. For example, in this case Project A has a higher discounted payback period but it's NPV and IRR are higher indicating big cashflows in later years. If those cashflows are realized then choosing Project B would turn out to be a wrong decision. I would recommend further analysis of the industry and calculating probability of cashflows each year so that we can incorporate them in our calculation as well.