Question

Charles and Caitlin are facing an important decision. After having discussed different financial scenarios, 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 $1,000,000 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 operating cash flows for this project (call it Project A) as follows:

PROJECT A YEAR 0 1 2 3 4 Expected CFs ($) -1,000,000 50,000 200,000 600,000 1,000,000 An alternative to pursuing this project would be to sell their innovative chip design to one of the established chip makers. This way, they would receive an upfront payment. But the amount would be relatively small – perhaps around $200,000 – 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. Dave and Eva were confident that they California State University | Monterey Bay 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 is expected to be only about five years. The initial investment for this project is estimated at $ 1,100,000. After taking into account the sale of their patent, the net investment would be $900,000. As for the future, Charles and Caitlin were pretty sure that there would be sizable profits in the first year. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry. Keeping this in mind, they estimate the future cash inflows for this project (call it Project B) as follows:

PROJECT B YEAR 0 1 2 3 4 Expected CFs ($) -900,000 650,000 650,000 550,000 300,000 Charles and Caitlin now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 20% 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 Charles and Caitlin have is regarding the reliability of their cash flow estimates. The analysis depends on the accuracy of those projected cash flows. However, they are both aware that actual future cash flows may be higher or lower.

ASSIGNMENT QUESTIONS

1. Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV, IRR, Profitability Index.

2. Charles believes that the best approach to make the decision is the NPV approach. However, Caitlin 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.

3. Which of these projects would you recommend? Explain why.

4. Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend.

Answer 1

Answer 1

Calculation of payback period

Payback period project A(Rank-2)

ProjectA	Amount($)	Amount($)
Years	Cash Inflows	Cumulitive Inflows
1	50000	50000
2	200000	250000
3	600000	850000
4	1000000	1850000
Investment	1000000
In 3rd year$ 850000 will be recovered

Payback period(A) = 3^rd year +$150000$1000000 ˣ 12 months

                       = 3 year 2 months

Payback period project B (Working with net investment no PV to be considered as the sale is made in 0 period )(Rank -1)

ProjectB	Amount($)	Amount($)
Years	Cash Inflows	Cumulitive Inflows
1	650000	650000
2	650000	1300000
3	550000	1850000
4	300000	2150000
Investment	900000
In 1st year $650000 is recovered

Payback period(B) = 1st year +$250000$650000 ˣ 12 months

                               = 1 year 5 month

As per Pack back method Project B should be chosen as the recovery time of the initial investment is much quicker.

Calculation of discounted payback period

Project A (Rank-2)

ProjectA	Amount($)	Discounting Factor	Amount($)
Years	Cash Inflows	20%	Present value(2nd column * 3rd column)
1	50000	0.833	41650
2	200000	0.694	138800
3	600000	0.579	347400
4	1000000	0.482	482000
		Total	1009850
Investment	1000000

Payback period(A) = 3^rd year +$472150$482000 ˣ 12 months

                  In 3 years about to 12 months the initial investment sum can be recovered ( Rank 2)

Project B   Working with net investment no PV to be considered as the sale is made in 0 period )(Rank – 1)

ProjectB	Amount($)	Discounting Factor	Amount($)
Years	Cash Inflows	20%	Present value(2nd column * 3rd column)
1	650000	0.833	541450
2	650000	0.694	451100
3	550000	0.579	318450
4	300000	0.482	144600
		Total	1455600
Investment	900000

Payback period(B) = 1st year +$358550$451100 ˣ 12 months

The initial invested sum is recovered within 1 year 10 months (Rank 1)

Here also Project B is earlier in recovering the investment amount so it should be chosen.

Calculation of NPV

Net present value = Present value of cash inflows – Initial outlay

Project A (Rank-2)

NPV = $50000 ˣ PV(20%,1y) +$200000 ˣ PV(20%,2y)+ $600000 ˣ PV(20%,3y)+

            $1000000 ˣ PV(20%,4y) - $1000000

        = $41650+$138800+$347400+$482000 - $1000000

        = $9850 (Rank 2)

1	650000	0.833	541450
2	650000	0.694	451100
3	550000	0.579	318450
4	300000	0.482	144600
		Total	1455600
Investment	900000		0

Project B (Rank-1)

Working with net investment no PV to be considered as the sale is made in 0 period

NPV = $650000 ˣ PV(20%,1y) +$650000 ˣ PV(20%,2y)+ $550000 ˣ PV(20%,3y)+

            $300000 ˣ PV(20%,4y) - $900000

NPV = $555600 (Rank-1)

Since NPV of Project B is greater so it should be chosen

Calculation of IRR

Project A(Rank-1)

Project A
Cash Inflows                  $
50000
200000
600000
1000000
1850000
1000000
Average of 4 years         cash flows                  462500
Investment/Average cash flow
2.162162162
30%

From the present value annuity factor chart table it is found that 2.16 is closer to 30% in the 4^th year. (Rank 1)

Project B(Rank – 2)

IRR of Project B
Project B	Amount($)
	650000
	650000
	550000
	300000
	2150000
Investment	900000
Average cash flow	537500
Investment/Average cash flow
	1.674418605
	45 to 46

From the present value annuity factor chart table it is found that 1.67 lies in between 45% to 46% in the 4^th year. If we take the average then the IRR is 45.5% (Rank -2)

Here, project A should be chosen as the IRR is 30% much below the IRR of project B

Calculation of profitability Index

Project A = PV of cash flowsPV of cash outlay = 10098501000000 = 1.01(Rank 2)

Project B= PV of cash flowsPV of cash outlay =1455600900000 = 1.61( Rank 1)

Answer2

In case of estimating future cash flows the most important factor to be considered is time value of money which is shown technically by applying discounting factor and is known as present value.

NPV and IRR are those two techniques which follow the path of the application of PV into the cash flows estimation. Therefore all other techniques are irrelevant and only NPV and IRR are relevant.

Between these two techniques the IRR refers that the discounting rate must be such which equalize present value of cash flow with the initial investment amount. However, in case of choosing discounting factor we have to look after the minimum rate of return which is equivalent with opportunity cost of capital. Most of the cases the opportunity cost of capital is more than IRR rate so the firm which seeks to maintain the cost of capital equals to IRR found difficulties to maintain such rate as it is very high.

On the other hand the Cost of capital in NPV is relevant as it considers opportunity cost of capital at same time the minimum hurdle rate the firm should consider.

Therefore, the belief of Charles is the best option.

Answer C

Since we consider the Charles belief we will consider project B as the NPV of project B is higher than Project A

Answer D

Limitations

Although we have chosen the NPV techniques for this project while assuming that cost of capital remains same throughout 4 years which is not possible due to the presence of systematic risks in the market which are known as external risks also known as macro factors like inflation, employment opportunities, interest rate risk, purchasing power risk.

The inflation must be considered while calculating NPV otherwise the PV figure shown in the NPV remains incorrect.