Problem:

Elizabeth Howards and Chris Browning are facing an important decision when it comes to

selecting between two mutually exclusive projects. After having discussed different financial

scenarios, the two engineers finalized their cash flow projections and wanted to move to the next

stage decide which of two possible mutually exclusive projects they should undertake.

When analyzing the projects, they estimated that they would need to spend about $1,250,000 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 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 could be sold to a larger chip manufacturer for a decent

sum. Accordingly, Elizabeth and Chris estimated the cash flows for this project (call it Project A)

as follows:

Year Project A

Expected Cash flows ($)

0 (1,250,000)

1 25,000

2 100,000

3 700,000

4 900,000

5 1,000,000

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.

In addition, Elizabeth and Chris 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 $ 1,100,000. After considering the sale of

their patent, the net investment would be $950,000. As for the future, the two engineers were

pretty 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 ($950,000)

1 550,000

2 550,000

3 650,000

4 400,000

5 150,000

Elizabeth and Chris now need to make their decision. For purposes of analysis, they plan to use a

required rate of return of 16% 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 Elizabeth and Chris 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

Suppose that Elizabeth and Chris hired you as a consultant to help them make the decision. 1. Please calculate the payback period (in years), the discounted payback period (in years), the net present value (NPV), the internal rate of return (IRR) and the modified internal rate of return (MIRR) for each project. Make sure you show the steps you follow (i.e., formula, calculator key-strokes, excel formula) and the results for each model.

What are your analysis and recommendations?