Why is the net present value is better than other investment rules for making capital budgeting decision? Critically assess the performance of NPV against other rules paying special attention to internal rate of return rule and identify characteristics that make it superior to these other rule under what circumstantial dose the NPV rule itself fills unless some adjustment are made ?
Why is the net present value is better than other investment rules for making capital budgeting decision? Critically assess the performance of NPV against other rules paying special attention to internal rate of return rule and identify characteristics that make it superior to these other rule under what circumstantial dose the NPV rule itself fills unless some adjustment are made ?
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Capital Budgeting Mini Case
Instructions: The assignment is based on the mini case below. The instructions relating to the assignment are at the end of the case.
Lucy Hawkins and Andy Chen 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 â 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 $5,000,000 on plant, equipment and supplies. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once the product had established a name for itself, the price could be raised. By the end of the fifth year, their product in its current form was likely to be obsolete. However, the innovative approach that they had devised and patented could be sold to a larger chip manufacturer for a decent sum. Accordingly, the two budding entrepreneurs estimated the operating cash flows for this project (call it Project A) as follows:
| Year | Project A Expected Cash flows ($) |
| 0 | (5,000,000) |
| 1 | 200,000 |
| 2 | 875,000 |
| 3 | 2,130,000 |
| 4 | 3,110,000 |
| 5 | 3,110,000 |
An alternative to pursuing this project would be to sell the patent for their innovative chip design to one of the established chip makers. They estimated that they would receive around $800,000 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.
Lucy and Andy 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 is expected to be only about five years.
The initial investment for this project is estimated at $ 5,000,000. After taking into account the sale of their patent, the net investment would be $4,200,000. As for the future, Lucy and Andy were pretty sure that there would be sizable profits in the first year. But thereafter, the zircon content problem would slowly start to disappear with advancing technology in the wafer industry. Keeping this in mind, they estimate the future cash inflows for this project (call it Project B) as follows:
| Year | Project B Expected Cash flows ($) |
| 0 | (4,200,000) |
| 1 | 2,500,000 |
| 2 | 2,000,000 |
| 3 | 900,000 |
| 4 | 550,000 |
| 5 | 250,000 |
Lucy and Andy 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 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:
| Metrics | Project A | Project B |
| Payback period (in years) | 3.58 | 1.85 |
| Discounted payback period (in years) | 4.64 | 2.87 |
| Net Present Value (NPV) | $560,421 | $516,723 |
| Internal Rate of Return (IRR) | 18.37% | 22.47% |
| Profitability Index | 1.11 | 1.12 |
| Modified Internal Rate of Return (MIRR) | 17.47% | 17.70% |
One of the concerns that Lucy and Andy have is regarding the reliability of their cash flow estimates. All the analysis in the table above is based on âexpectedâ cash flows. However, they are both aware that actual future cash flows may be higher or lower.
Assignment:
Suppose that Lucy and Andy 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) Andy believes that the best approach to make the decision is the NPV approach. However, Lucy 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 includes 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 provides 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.
