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.

1. 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.

Answer 1

Ranking of Project based on metrix as below

Rank of Project based of Metrix
No.	Metrics	Project A	Project B
1	Payback period (in years)	3.74	1.76
	Rank	2	1
2	Discounted payback period (in years)	4.69	2.75
	Rank	2	1
3	Net Present Value (NPV)	$478,592	$463,480
	Rank	1	2
4	Internal Rate of Return (IRR)	19.77%	24.03%
	Rank	2	1
5	Profitability Index	1.1276	1.1287
	Rank	2	1
6	Modified Internal Rate of Return (MIRR)	18.82%	18.84%
	Rank	2	1

2. Net Present Value is best method for decision making of which project should be accepted.

(A) Comparision Net Present Value and Payback period

Payback period not consider time value of money while NPV consider time value of money.

Payback period not consider the cash flow after payback period.

(B) Comparision of Net Present Value and Discounted Payback Period

Discounted payback period is advance version of payback period. Discounted payback not consider cash flow after payback period so Net present value is better than Discounted payback period.

(C) Comparision of Net Present Value and Internal Rate of Return

Internal Rate of Return 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, Net Present Value talks in absolute terms and therefore this point is not missed.

Internal Rate of Return assumes discounting and reinvestment of cash flows at the same rate but it is practically not possible to invest money at this rate in the market. Whereas, Net Present Value assumes a rate of borrowing as well as lending near to the market rates and not absolutely impractical.

Internal Rate of Return enters the problem of multiple Internal Rate of Returrn when we have more than one negative net cash flow and the equation is then satisfied with two values, therefore, have multiple Internal Rate of Returns. Such a problem does not exist with Net Present Value.

(D) Comparision of Net Present Value and Profitibility Index

Profitability index is a ratio between the discounted cash inflow to the initial cash outflow. It presents a value which says how many times of the investment is the returns in the form of discounted cash flows.

The disadvantage associated with this method again is its relativity. A project can have the same profitability index with different investments and the vast difference in absolute dollar return. NPV has an upper hand in this case.

(E) Comparision of Net Present Value and Modified Internal Rate of Return

Modified Internal Rate of Return fail to capture the Present Value of money and are hence called 'Internal' Rates! The best method must factor Internal Return as well as the Cost of Capital to determine Present Value. The Net Present Value method aims to capture both and hence is the preferred.