Question

Maya Lee and John Spencer 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 $2,500,000 on plant, equipment and supplies. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once the product had established a name for itself, the price could be raised. By the end of the fifth year, their product in its current form was likely to be obsolete. However, the innovative approach that they had devised and patented could be sold to a larger chip manufacturer for a decent sum. Accordingly, the two budding entrepreneurs estimated the cash flows for this project (call it Project A) as follows: Year Project A Expected Cash flows ($) 0 ($2,500,000) 1 $290,000 2 $400,000 3 $880,000 4 $1,600,000 5 $1,600,000 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. 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. Maya and John 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 $ 2,600,000. After taking into account the sale of their patent, the net investment would be $2,400,000. As for the future, Maya and John were reasonably sure that there would be sizable profits in the first couple of years. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry. Keeping all this in mind, they estimate the cash flows for this project as follows: Year Project B Expected Cash flows ($) 0 ($2,400,000) 1 $1,450,000 2 $1,215,000 3 $470,000 4 $285,000 5 $165,000 Maya and John 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) 3.58 1.78 Discounted payback period (in years) 4.57 2.71 Net Present Value (NPV) $343,534 $333,601 Internal Rate of Return (IRR) 19.22% 23.50% Profitability Index 1.1374 1.1390 Modified Internal Rate of Return (MIRR) 18.00% 18.03% One of the concerns that Maya and John 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 Maya and John have hired you as a consultant to help them make the decision. Please draft an official memo to them with your analysis and recommendations.
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) John believes that the best approach to make the decision is the NPV approach. However, Maya 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

1.)

Facts and data Derived from the question is given below:-

cash flow pf project A

project A	year	0	1	2	3	4	5
project A	cash flow	$2,500,000.00	$290,000.00	$400,000.00	$880,000.00	$1,600,000.00	$1,600,000.00

Cash flow of project B

Project B	year	0	1	2	3	4	5
	cash flow	$2,400,000	$1,450,000.00	$1,215,000.00	$470,000.00	$285,000.00	$165,000.00

Given financials/data:-

	Project A	Project B
Payback period	3.58	1.78	years
discounted payback period	4.57	2.71	years
NPV	$343,534	$333,601
IRR	19.22%	23.50%
profitablity index	1.1374	1.139
MIRR	18%	18.03%

The main issue here is to decode or understand the financial figures. Well, by looking at the above financials (I did my own calculation and found them right and concluded that those numbers are not random), each parameters has their own importance and taking decision by considering only one number is not at all justifiable. so, in order to reach to the conclusion ,we must first understand the technicalities and importance of the financials terms given above.

a) Payback period:-   It is nothing but the time require to get back or recover the investment. Shorter payback period means more attractive investment.

b) Discounted payback period:- Discounted payback period is nothing but just discount the cash flows and then calculate the payback period. This is more realistic than the payback period. Shorter Discounted payback period is more attractive investment.

c) NPV:- The full form of it is to net present value. It is the difference between the present value of the cash inflows and cash outflows over a period of time. positive and larger NPV values are preferable.

d) IRR:- The full form of it is to Internal Rate of Return. It is mainly the discount rate at which the NPV of the project becomes zero. IRR of an investment or a project must be greater than the cost of capital.

e) Profitability index:- profitability index is the relationship between cost and benefits of a proposed project through the use of ratio. The benchmark for profitability index is 1.0, PE greater than 1 considers good and less than 1 indicates the PV is less than the project investment.

f) MIRR:-   Modified internal rate of return assumes that the cash flows (positive) is reinvested at the firm's cost of capital and the initial investments are financed at the firm's financing cost. It improves on IRR as it generates only one solution eliminating the issue of multiple IRRs.

By understanding all the terms, we can easily conclude that by considering payback period, discounted payback period, IRR, profitability index project B is better than project A.

2. There can be many approaches to reach to a conclusion like NPV approach, IRR approach, MIRR approach and every term is being explained in detail to come to the conclusion.

3.

	Project A	Project B	Rank
Payback period	3.58	1.78	project B
discounted payback period	4.57	2.71	project B
NPV	$343,534	$333,601	Project A
IRR	19.22%	23.50%	Project B
profitablity index	1.1374	1.139	Project B
MIRR	18%	18.03%	Project B

NPV method approach is good one but I will suggest the to go for MIRR approach as it is better than all the approaches. MIRR gives most realistic figure among all by considering all future cash flows to be reinvested into the company at its cost of capital. MIRR higher the company cost of capital is a good decision for a company to take up. I personally that MIRR is enough to take up the decision as most of the numbers are in favor of project B.