Dan and Susan are faced with an important decision. After having discussed different financial scenarios, the two
Question:
Dan and Susan are faced with 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 on to the next stage: deciding which of two possible projects they should undertake.
They both had engineering degrees and had worked for several years as maintenance engineers at a large chip manufacturing company. About six months ago, they were able to exercise their first stock options. It was then that they decided to quit their secure and stable job and pursue their dreams of starting their own business. In their spare time, almost as a hobby, they had been helping research a new chip that could speed up certain specialized tasks by up to 25%. At this point, the chip design was complete. While further experimentation could improve the performance of your design, any delay in entering the market now could prove costly, as one of the established players could come up with a similar product of their own.
They estimated that they would need to spend about $1,000,000 on plants, equipment, and supplies. As for future cash flows, they felt that the correct strategy, at least for the first year, would be to sell their product at very low prices to induce customer acceptance. Then, once the product had established a name for itself, the price could be increased. By the end of the fifth year, your product in its current form was likely to be obsolete. However, the innovative approach they had devised and patented could be sold to a larger chipmaker for a decent sum. Consequently, the two budding entrepreneurs estimated the cash flows for this project (call it Project A) as follows:
Year | Project A Expected cash flows ($) |
0 | (1,000,000) |
1 | 50,000 |
2 | 200,000 |
3 | 600.000 |
4 | 1,000,000 |
5 | 1,500,000 |
An alternative to continuing with this project would be to immediately sell the patent for your innovative chip design to one of the established chip makers. They estimated that they would receive around $200,000 for this. It probably wouldn't be reasonable to expect much longer, since neither his product nor his innovative approach had a track record.
They could then invest in some plant and equipment that would test the 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 zircon level was currently being done by the chipmakers themselves. However, many of them, especially the smaller ones, did not have the capacity to allow 100% verification. Most tasted only a sample of the wafers they received.
Dan and Susan were confident that they could persuade at least some of the chipmakers to outsource this function to them. By specializing exclusively in this task, your small business could cut costs by more than half, thereby allowing chipmakers to perform 100% quality control for about the same cost they incurred for quality control. partial quality. today. The life of this project (let's call it project B) is also expected to be about five years.
The initial investment for this project is estimated at $1,100,000. After taking into account the sale of your patent, the net investment would be $900,000. As for the future, Dan and Susan were pretty sure there would be sizable gains in the first two years. But from then on, the problem of zircon content would slowly start to disappear with the advancement of technology in the wafer industry. Taking all this into account, they estimate the cash flows for this project as follows:
Year | Project B Expected cash flows ($) |
0 | ($900,000) |
1 | 650.000 |
2 | 650.000 |
3 | 550.000 |
4 | 300.000 |
5 | 100,000 |
Dan and Susan must now make a decision. For analysis purposes, they plan to use a required rate of return of 20% for both projects. Ideally, they would prefer the project they choose to have a payback period of less than 3.5 years and a discounted payback period of less than 4 years.
Below are the results of the analysis they have carried out so far:
Metric | Project A | Project B |
Payback period (in years) | 3.15 | 1.38 |
Discounted payback period (in years) | 3.98 | 1.79 |
Net Present Value (NPV) | $612,847 | $ 596,206 |
Internal Rate of Return (IRR) | 35,93% | 55,07% |
Profitability Index | 1.61 | 1.66 |
Be sure to validate the above results. One concern Dan and Susan have is the reliability of their cash flow estimates. All of the analysis in the table above is based on “expected” cash flows. However, both are aware that actual future cash flows may be higher or lower.
Assignment:
Suppose that Dan and Susan have hired you as a consultant to help them make the decision. Draft an official 2-page memo to them with your analysis and recommendations.
Your presentation should cover the following questions:
1. Briefly summarize the key facts of the case and identify the problem facing our two budding entrepreneurs. In other words, what is the decision they must make?
2. What are some approaches that can be used to solve this problem? What are some criteria or metrics that can be used to help make this decision?
An excellent document will propose solutions that are sensitive to all the problems identified.
3. a) Classify the projects based on each of the following metrics: payback period, discounted payback period, GO, IRR, profitability index.
b) Susan believes that the best approach to make the decision is the NPV approach. However, Dan isn't 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.
An excellent document includes a solutions assessment that contains thorough and insightful explanations, the feasibility of the solutions, and the impacts of the solutions.
4. a) Which of these projects would you recommend? Explain why.
b) Briefly state the limitations of the approach you used to make this decision and describe what further analysis you would recommend.
An excellent document provides concise but comprehensive action-oriented recommendations using appropriate justifications from the subject matter related to the problem while addressing the limitations of the solution and describing recommended future analysis.
Management Accounting Information for Decision-Making and Strategy Execution
ISBN: 978-0137024971
6th Edition
Authors: Anthony A. Atkinson, Robert S. Kaplan, Ella Mae Matsumura, S. Mark Young