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.

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?

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.

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

Ans 1) The key facts of the case are that Katie Holmes and Sam Wilson have to choose between two projects one involves the manufacturing of new chip that could speed up certain specialized tasks by as much as 25% and the other involves selling the patent to some company and using the cashflow to test silicon wafers for zircon content and they can render this service to other small company for 100% quality checking of their product for the same cost.

The problem being faced by two entrepreneurs are that Project A will give have low cash inflow in immediate years and high cash inflow in future years whereas project B will be having high cash inflow in immediate years and less cash inflow in future years. They need to decide which project they should choose.

Ans 2) Some of the capital budgeting techniques that can be used to solve the problem are:

1. Payback period

2. Discounted payback period

3. Net Present Value (NPV)

4. Profitability Index

5. Annualised NPV

6. Internal Rate of Return (IRR)

7. MIRR

8. Accounting rate of return

some various criteria or metrics that can be used to help make this decision are:

1. Payback period - Shorter the period better the project

2. Discounted payback period - Shorter the period better the project

3. Net Present Value (NPV)

a. NPV > 0, accept the project

b. NPV = 0, accept the project

c. NPV < 0, reject the project

4. Profitability Index

a. PI > 1, accept the project

b. PI = 1, accept the project

c. PI < 1, reject the project

5. Annualised NPV - same rule as of NPV

6. Internal Rate of Return (IRR)

a. IRR > ROR, accept the project

b. IRR = ROR, accept the project

c. IRR < ROR, reject the project

7. MIRR - same rule as IRR

8. Accounting rate of return - Higher the return better the project

Ans 3)a)

Metrics	Project A	Project B
Payback period	2	1
Discounted payback period	2	1
NPV	1	2
IRR	2	1
Profitability Index	2	1
MIRR	2	1

Ans 3)b) The best approach is NPV.

At the end of the day, the only thing that matters are the amount of positive cash flow enjoyed by a project keeping in mind the following assumptions do not change:

1. There is no risk

2. There is no inflation

3) The lifecycle of the project does not change

Ans 4)a) I would recommend Project A as the net cash flow is maximum in this project and as there is no other variable in this project we can easily assume that this net cash flow is the profit of the project. So, project A has the highest profit so we should select this project.

Ans 4)b) The assumptions of this approach are:

1. There is no risk

2. There is no inflation

3) The lifecycle of the project does not change

4) There is no Exchange risk