Question

Rosa Lee and Scott Bradshaw 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 $5,000,000 on plant, equipment and working capital. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once the product had established a name for itself, the price could be raised. By the end of the fifth year, their product in its current form was likely to be obsolete. However, the innovative approach that they had devised and patented could be sold to a larger chip manufacturer for a decent sum. Accordingly, the two budding entrepreneurs estimated the cash flows for this project (call it Project A) as follows:
Year
Project A
Expected Cash flows ($)
0
($5,000,000)
1
$190,000
2
$885,000
3
$2,140,000
4
$3,110,000
5
$3,110,000

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.

Rosa and Scott 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 $4,900,000. After taking into account the sale of their patent, the net investment would be $4,600,000. As for the future, Rosa and Scott 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
($4,600,000)
1
$3,088,700
2
$1,916,600
3
$867,300
4
$527,000
5
$239,600

Rosa and Scott 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)
3.57
1.79
Discounted payback period (in years)
4.63
2.82
Net Present Value (NPV)
$565,862
$525,752
Internal Rate of Return (IRR)
18.40%
22.36%
Profitability Index
1.1132
1.1143
Modified Internal Rate of Return (MIRR)
17.49%
17.52%

One of the concerns that Rosa and Scott have is regarding the validity of the assumptions they made in estimating the cash flows. 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 Rosa and Scott 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:

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? (10 points)

An excellent paper will demonstrate the ability to construct a clear and insightful problem statement while identifying all underlying issues.

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? (10 points)

An excellent paper will propose solutions that are sensitive to all the identified issues.

a) Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV, IRR, Profitability Index, and MIRR. (10 points)

b) Scott believes that the best approach to make the decision is the NPV approach. However, Rosa 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. (20 points)

An excellent paper will include an evaluation of solutions containing thorough and insightful explanations, feasibility of solutions, and impacts of solutions.

a) Which of these projects would you recommend? Explain why. (10 points)

b) Briefly state the limitations of the approach you used in making this decision, and outline what further analysis you would recommend. (20 points)

An excellent paper will provide concise yet thorough action-oriented recommendations using appropriate subject-matter justifications related to the problem while addressing limitations of the solution and outlining recommended future analysis.

Answer 1

a)

Ranking

	Rank 1	Rank 2
Payback period (in years)	B	A
Discounted payback period (in years)	B	A
Net Present Value (NPV)	A	B
Internal Rate of Return (IRR)	B	A
Profitability Index	B	A
Modified Internal Rate of Return (MIRR)	B	A

Payback amount - Indicates the time it'll want recover the initial value of the project, that the lower the payback amount is that the higher the project is. Discounted payback amount - Same goes for the discounted payback wherever we have a tendency to see the time it'll want recover the initial value through discounted future money flows. once more the lower it's the higher it'll be. NPV - web gift worth is nothing however the current worth of expected future money flows discounted at the expected rate of come back. So, the upper this gift worth higher it's for the capitalist. (Is in absolute terms) IRR - Internal rate of come back is largely the speed of come back at that the NPV of the project is zero, that is, the money outflows ar capable the discounted worth of money inflows. So, IRR is marginally the most rate of come back which might be expected from the project. So, higher the IRR the higher it's. Profitability Index - it's primarily the quantitative relation of discounted money inflows and money outflows. So, it's money flow per unit of money outflow. the upper it's the higher the project is. (It is in relative terms) MIRR - changed rate of come back is that the IRR with the essential distinction as wherever IRR assumes that the money flows ar reinvested at the project's IRR rate, MIRR assumes that the money flows ar reinvested at the speed of value of capital solely, that is taken into account as a additional realistic assumption during a real world state of affairs. once more the upper it's the higher the project is. b) NPV is Associate in Nursing approach that primarily provides absolutely the worth addition to the capitalist, in alternative words, it's web quantity the capitalist is anticipated to earn from the project. Now, it's during a method continuously higher to possess the next quantity of money as a result of the last word objective of any capitalist is wealth maximation. however if we have a tendency to take into thought this scenario then the largest disadvantage of wishing on NPV is that the distinction in their initial outflows. this can be as a result of NPV is evaluating the project in absolute terms wherever it's not taken into the thought the actual fact that the initial investment demand for each the comes is totally different. that's {even though|albeit|although|even if|even supposing|despite the actual fact that} cyber web relisation from Project A is over B there remains the fact that the initial investment demand of A is additionally additional that B. So, as during this case since there's a desire to match the comes it's necessary to possess a relative comparison between the 2. Therefore, rather than wishing on NPV they have to check the profit index that may be a similar approach to NPV with the essential distinction of being relative as compared to NPV, beacuse it provides the money flow per unit of money outflow and so, be considered higher metric for scrutiny the 2 comes. The results for MIRR ought to even be taken into thought thanks to the foremost reasons: 1. distinction in initial income - thanks to the distinction within the initial cashflow demand it's clear that we have a tendency to should take relative comparison rather than absolute (NPV), and MIRR provides cyber web relative profit. 2. money flow temporal arrangement - currently since we have a tendency to ar talking regarding the expected future cashflows and value of cash, thus in such cases it's continuously most popular to possess comes which give higher cashflows within the initial years as compared to those which give high cashflows within the later years of the project. Now, since here the reinvestment rate assumed by MIRR is value of capital solely, thus it ought to be thought of. Therefore, each profit index and MIRR can offer higher results as a result of we have a tendency to ar talking in relative terms with distinction within the initial investment. As, for the opposite metrics: Payback amount - it is clearly discarded, since it doesn't take into consideration the value of cash. Discounted payback amount - it can even be discarded thanks to truth it doesn't take into consideration the cashflows when the payback amount. the metric is barely involved with recovery of initial investment, there's no thought for profit. IRR - IRR can even be discarded given its limitation that it takes the reinvesment rate of the money flows to be the project's IRR not the price of capital that isn't considered realistic. So, it'll be higher to travel for MIRR than IRR.