Question

Elizabeth Howards and Chris Browning are facing an important decision when it comes to selecting between two mutually exclusive projects. After having discussed different financial scenarios, the two engineers finalized their cash flow projections and wanted to move to the next stage – decide which of two possible mutually exclusive projects they should undertake.

When analyzing the projects, 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 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 could be sold to a larger chip manufacturer for a decent sum. Accordingly, Elizabeth and Chris estimated the cash flows for this project (call it Project A) as follows:

Year	Project A Expected Cash flows ($)
0	(1,250,000)
1	25,000
2	100,000
3	700,000
4	900,000
5	1,000,000

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 $200,000 for this. It would probably not be reasonable to expect much more as neither their product nor their innovative approach had a track record.

In addition, Elizabeth and Chris 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 $ 1,100,000. After considering the sale of their patent, the net investment would be $950,000. As for the future, the two engineers 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	($950,000)
1	550,000
2	550,000
3	650,000
4	400,000
5	150,000

Elizabeth and Chris 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 3.5 years and a discounted payback period of less than 4 years.

One of the concerns that Elizabeth and Chris 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.

Suppose that Elizabeth and Chris hired you as a consultant to help them make the decision.

1. Please calculate the payback period (in years), the discounted payback period (in years), the net present value (NPV), the internal rate of return (IRR) and the modified internal rate of return (MIRR) for each project. Make sure you show the steps you follow (i.e., formula, calculator key strokes, excel formula) and the results for each model. (50 points)

2. Draft an official memo to the engineers with your analysis and recommendations. (50 points)

Your memo 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? (5 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? (5 points)

3. Rank the projects based on each of the following metrics: Payback Period, Discounted Payback Period, NPV, IRR, and MIRR. (5 points)

4. Chris believes that the best approach to make the decision is the NPV approach. However, Elizabeth 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. (15 points)

5. Which of these projects would you recommend? Explain why. (5 points)

6. Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend. (15 points)

Answer 1

	Expected Cash flows ($)		PV of cash flows		NPV		IRR		MIRR		Payback Period		Discounted Payback Period
Year	Project A	Project B	Project A	Project B	Project A	Project B	Project A	Project B	Project A	Project B	Project A	Project B	Project A	Project B
0	($1,250,000)	($950,000)	(1,250,000.00)	(950,000.00)	267,503.39	641,638.41	21.99%	46.31%	20.59%	28.61%	3.472	1.727	4.456	2.164
1	$25,000	$550,000	21,551.72	474,137.93			=IRR(B5:B10)	=IRR(C5:C10)	=MIRR(B5:B10,16%,16%)	=MIRR(C5:CB10,16%,16%)	=3+(1250000-25000-100000-700000)/900000	=1+(950000-550000)/550000	=4+(1250000-21552-74316-448460-479062)/497062	=2+(950000-474138-408740)/408740
2	$100,000	$550,000	74,316.29	408,739.60
3	$700,000	$650,000	448,460.37	416,427.49
4	$900,000	$400,000	497,061.99	220,916.44
5	$1,000,000	$150,000	476,113.02	71,416.95
Total income	$2,725,000	$2,300,000	=individual cash flow/(1+16%)^(year of cash flow)
Total CF	$1,475,000	$1,350,000

Elizabeth Howards and Chris Browning hold a patent for manufacturing process of chips. The problem in hand is to determine whether to undertake the new venture to manufacture, market and grow the business of chips manufacturing or to sell the patent right away and focus only on becoming the manufacturer of the chips. In the first choice they can develop a whole new business and become a brand of their own. In second choice, they can be the niche and expert manufacturers and realize the benefit of scale. Even if this is drafted as a financial problem, it is more than just a financial decision. It is more of a strategic decision. They need to decide whether they want to the latest brand of the chip designers and manufacturers or only the large scale manufacturers and supply their product to the currently established brands.

It appears that we have a clear winner here. We have performed the cost-benefit analysis of both the projects and by all parameters, project B appears to be better choice financially than project A. Even though total cash flows and net cash flows from project A in nominal terms are higher, the cash flows are more irregular and coming in later in the life of the project. The cash flows from b are more stable, and have higher discounted value. Hence, we should choose project B which is better choice financially. Moreover, in project B, the risk for the entrepreneurs is lower as they are only looking at the manufacturing aspect. In project A, they own the complete process from manufacturing to marketing to managing the whole supply chain. Hence, project A is riskier. Even though we have considered equal required rate of return for both the projects, it can be intuitively observed that project A is riskier than B. Since the future cash flows are an estimate, we can perform a scenario analysis to check the profitability of each project under different scenarios. the scenarios need to be quantified in the financial terms. We can also calculated cash flows under the optimistic, pessimistic and realistic scenarios and give a probability of realizing each of the case. The probability weighted or most likely NPV of each project could help us in making the decisions under various economic and business conditions.

Project rankings

	Rank 1	Rank 2
NPV	Project B	Project A
IRR	Project B	Project A
MIRR	Project B	Project A
Payback	Project B	Project A
Discounted payback	Project B	Project A

NPV is generally considered as the better approach for decision making as compared to any other approach. The investors need an absolute or $$ return for their investments, which is quantified by NPV. IRR could be used to determined to judge a project in isolation to check if it will deliver a rate of return higher than the cost of funds. Modified IRR is a modification to the IRR method where the reinvestment rate is also accounted for. Payback and discounted payback periods are generally congruent with IRR. In this case, the estimation of future cash flows could vary to a great extent as this is a newly developed technology. The future cash flows can not be reliably predicted which makes reliance on NPV questionable. IRR will a better method to judge such developmental projects where the rate of return on the project is calculated rather than absolute cash flows. Higher the margin (IRR), higher the room for variance and higher the likelihood of profit.

In this case, project B appears to be superior to project A based on all the parameters. Hence, we should choose this project.

The limitations are, as mentioned earlier, the predictability of cash flows. Since this is a new development the future cash flows can not be reliably predicted. A scenarios analysis would be a better approach to support the profitability calculation and cost-benefit analysis.