Question

Capital Budgeting Mini Case

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

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? (10 points)

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

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.

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. (20 points)

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

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

FACTS OF THE CASE

The engineers have designed a new chip that could speed up their specialised tasks.Based on this innovation, they want to market a new product(Project A) for which they have developed forecasf for cash inflows and outflows

Another option available with them is to sell the patent for their innovative chip design to one of the established chip makers for $100000. They could then invest in some plant and equipment that would test silicon wafers for zircon content before wafers were used to make chips.They expect that the chip makers would outsource this function to them, because the chipmakers were currently making only partial quality checks as they did not have the capacity to do 100% checking..By specialising in this task , their company would be able to slash costs and allow the chip manufacturesrs to go for 100% quality checks at roughly the same cost at which they were incurring for partial quality checks. This is Project B

IDENTIFICATION OF THE PROBLEM

The engineers would like to take the decision ,whether to go in for Project A or Project B, based on the analysis they have made

answera

RANKING OF THE PROJECTS

METRICS	PROJECTA	PROJECT B	RANKING
payback	3.54 yrs	1.80 yrs	project A
discounted payback	4.58 yrs	2.72 yrs	Project A
NPV	$160816	$151742	Project A
IRR	18.90%	23.84%	Project B
profitability index	1.13	1.14	project B
MIRR	17.82%	18.15%	Project B

As per the payback, discounted payback and NPV project A is prefered. However as per IRR method, profitability method and MIRR , project B is preferred

answer b

pay back method considers only the liquidity of the project, that is in how many years ,you can recover your original investment.But it does not consider the profitability of the project , because it ignores the cashflows received after the payback period (years) is over

Discounted payback method also suffers from the same limitation but it is better than pay back period, because here the cashflows are discounted at cost of capital (which is 15% here)

So both these methods are not very suitable for evaluatio\n

NPV method cosnsiders time value of money.It also considers all cashflows

NPV method is instrumental in achieving the objective of wealth maximisation of shareholders, because It chooses projects whose present value of inflows are greater than initial investment. Or rate of return on project is greater than cost of capital/discount rate.

Profitability method and NPV method give different rankings because NPV is an absolute measure, (NPV= present value of cash inflows- initial investment, whereas profitability index is a relative measure (profitability index= Present value of inflows/initial investment)

IRR is the discount rate which equates present value of future cash inflows with the initial investment, Or the discount rate which makes its NPV=zero.

The limitation of IRR method is that it assumes that all intermediate cashflows are reinvested at the IRR.The reinvestment \rate assumption under IRR is very unrealistic.

MIRR is superior to IRR in a way. MIRR assumes that project cashflows are reinvested at the cost of capital, whereas regular IRR assumes that the project cashflows are reinvested at the project's own IRR.Since reinvestment at cost of capital ( or some other explicit rate ) is more realistic than reinvestment at IRR,MIRR reflects the true profitability of the project better

answerc RECOMMENDATION

ranking of projects is different on the basis of NPV and IRR

This is because the projects differ on the basis of cashflows generated (time disparity ), although their lives are same (5 yrs), and their initial investment do not differ much

for project A, the cashflows are lower in the initial period, whereas for project B, the cashflows are higher in the initial period

under the time disparity problem , IRR rule can be misleading.

for mutually exclusive projects ,it is better to rely on rankings given by the NPV method., because higher NPV contributes more to the value of the firm.

answerd

To incorporate risk in capital budgeting we can use sensitivity analysis , or scenario analysis to find out what happens to NPV when there is change in some variable,like cashflow, initial investment etc

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