Please read the case below and help with recommendations:

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.

The case is below

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

1

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.

2

Below are the results of the analysis they have to carry out (

you are asked to do

):

Metrics

Project A

Project B

Payback period (in years)

Discounted payback period (in years)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index

Modified Internal Rate of Return (MIRR)

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 recommendation.