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FIN 4830 Chapter : Apple IPhone Case

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azuremammoth471
15 Mar 2019
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LSU
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Finance
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FIN 4830
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Document Summary

Study questions: explain gaap, non-gaap numbers and their impact on financial statements, when apple recognized revenues under gaap they used the subscription method, like a magazine company would use. This was because they wanted to amortize the sale of the iphone over the 2 year term of its service contract. Apple would recognize part of the sale in the quarter in which it took place and move the rest to unearned revenue to be recognized in the future. The non-gaap numbers they established recognized all of the revenue from the sale in the current period. The subscription nature of the iphone sales coerced them company"s performance. The subscription method used in forming the gaap numbers made it complicated and unclear as a whole: should apple lobby for their non-gaap numbers to be sanctioned by the. Fasb: i think it would be beneficial for apple to pursue this.

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Related Questions

During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by Nortel’s auditors from Deloitte & Touche. Judge Marrocco accepted these arguments. Marrocco added he was “not satisfied beyond a reasonable doubt” that the trio (i.e., Dunn, Beatty, and Gollogly) had “deliberately misrepresented” financial results. Given the facts of the case, do you believe Judge Marrocco’s decision was justified? Explain.

Canada-based Nortel Networks was one of the largest telecommunications equipment companies in the world prior to its filing for bankruptcy protection on January 14, 2009, in the United States, Canada, and Europe. The company had been subjected to several financial reporting investigations by U.S. and Canadian securities agencies in 2004. The accounting irregularities centered on premature revenue recognition and hidden cash reserves used to manipulate financial statements. The goal was to present the company in a positive light so that investors would buy (hold) Nortel stock, thereby inflating the stock price. Although Nortel was an international company, the listing of its securities on U.S. stock exchanges subjected it to all SEC regulations, along with the requirement to register its financial statements with the SEC and prepare them in accordance with U.S. GAAP.

The company had gambled by investing heavily in Code Division Multiple Access (CDMA) wireless cellular technology during the 1990s in an attempt to gain access to the growing European and Asian markets. However, many wireless carriers in the aforementioned markets opted for rival Global System Mobile (GSM) wireless technology instead. Coupled with a worldwide economic slowdown in the technology sector, Nortel’s losses mounted to $27.3 billion by 2001, resulting in the termination of two-thirds of its workforce.

The Nortel fraud primarily involved four members of Nortel’s senior management as follows: CEO Frank Dunn, CFO Douglas Beatty, controller Michael Gollogly, and assistant controller Maryanne Pahapill. At the time of the audit, Dunn was a certified management accountant, while Beatty, Gollogly, and Pahapill were chartered accountants in Canada.

Accounting Irregularities

On March 12, 2007, the SEC alleged the following in a complaint against Nortel:1

In late 2000, Beatty and Pahapill implemented changes to Nortel’s revenue recognition policies that violated U.S. GAAP, specifically to pull forward revenue to meet publicly announced revenue targets. These actions improperly boosted Nortel’s fourth quarter and fiscal 2000 revenue by over $1 billion, while at the same time allowing the company to meet, but not exceed, market expectations. However, because their efforts pulled in more revenue than needed to meet those targets, Dunn, Beatty, and Pahapill selectively reversed certain revenue entries during the 2000 year-end closing process.

In November 2002, Dunn, Beatty, and Gollogly learned that Nortel was carrying over $300 million in excess reserves. The three did not release these excess reserves into income as required under U.S. GAAP. Instead, they concealed their existence and maintained them for later use. Further, Beatty, Dunn, and Gollogly directed the establishment of yet another $151 million in unnecessary reserves during the 2002 year-end closing process to avoid posting a profit and paying bonuses earlier than Dunn had predicted publicly. These reserve manipulations erased Nortel’s pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead.2

In the first and second quarters of 2003, Dunn, Beatty, and Gollogly directed the release of at least $490 million of excess reserves specifically to boost earnings, fabricate profits, and pay bonuses. These efforts turned Nortel’s first-quarter 2003 loss into a reported profit under U.S. GAAP, which allowed Dunn to claim that he had brought Nortel to profitability a quarter ahead of schedule. In the second quarter of 2003, their efforts largely erased Nortel’s quarterly loss and generated a pro forma profit. In both quarters, Nortel posted sufficient earnings to pay tens of millions of dollars in so-called return to profitability bonuses, largely to a select group of senior managers.

During the second half of 2003, Dunn and Beatty repeatedly misled investors as to why Nortel was conducting a purportedly “comprehensive review” of its assets and liabilities, which resulted in Nortel’s restatement of approximately $948 million in liabilities in November 2003. Dunn and Beatty falsely represented to the public that the restatement was caused solely by internal control mistakes. In reality, Nortel’s first restatement was necessitated by the intentional improper handling of reserves, which occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid uncovering Dunn, Beatty, and Gollogly’s earnings management activities.

The complaint charged Dunn, Beatty, Gollogly, and Pahapill with violating and/or aiding and abetting violations of the antifraud, reporting, and books and records requirements. In addition, they were charged with violating the Securities Exchange Act Section 13(b)(2)(B) that requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with U.S. GAAP and to maintain accountability for the issuer’s assets.

Dunn and Beatty were separately charged with violations of the officer certification provisions instituted by SOX under Section 302. The commission sought a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants.

Specifics of Earnings Management Techniques

From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its financial results for year-end 2000, Dunn, Beatty, and Pahapill altered Nortel’s revenue recognition policies to accelerate revenues as needed to meet Nortel’s quarterly and annual revenue guidance, and to hide the worsening condition of Nortel’s business. Techniques used to accomplish this goal include:

Reinstituting bill-and-hold transactions. The company tried to find a solution for the hundreds of millions of dollars in inventory that was sitting in Nortel’s warehouses and offsite storage locations. Revenues could not be recognized for this inventory because U.S. GAAP revenue recognition rules generally require goods to be delivered to the buyer before revenue can be recognized. This inventory grew, in part, because orders were slowing and, in June 2000, Nortel had banned bill-and-hold transactions from its sales and accounting practices. The company reinstituted bill-and-hold sales when it became clear that it fell short of earnings guidance. In all, Nortel accelerated into 2000 more than $1 billion in revenues through its improper use of bill-and-hold transactions.

Restructuring business-asset write-downs. Beginning in February 2001, Nortel suffered serious losses when it finally lowered its earnings guidance to account for the fact that its business was suffering from the same widespread economic downturn that affected the entire telecommunications industry. As Nortel’s business plummeted throughout the remainder of 2001, the company reacted by implementing a restructuring that, among other things, reduced its workforce by two-thirds and resulted in a significant write-down of assets.

Creating reserves. In relation to writing down the assets, Nortel established reserves that were used to manage earnings. Assisted by defendants Beatty and Gollogly, Dunn manipulated the company’s reserves to manage Nortel’s publicly reported earnings, create the false appearance that his leadership and business acumen was responsible for Nortel’s profitability, and pay bonuses to these three defendants and other Nortel executives.

Releasing reserves into income. From at least July 2002 through June 2003, Dunn, Beatty, and Gollogly released excess reserves to meet Dunn’s unrealistic and overly aggressive earnings targets. When Nortel internally (and unexpectedly) determined that it would return to profitability in the fourth quarter of 2002, the reserves were used to reduce earnings for the quarter, avoid reporting a profit earlier than Dunn had publicly predicted, and create a stockpile of reserves that could be (and were) released in the future as necessary to meet Dunn’s prediction of profitability by the second quarter of 2003. When 2003 turned out to be rockier than expected, Dunn, Beatty, and Gollogly orchestrated the release of excess reserves to cause Nortel to report a profit in the first quarter of 2003, a quarter earlier than the public expected, and to pay defendants and others substantial bonuses that were awarded for achieving profitability on a pro forma basis. Because their actions drew the attention of Nortel’s outside auditors, they made only a portion of the planned reserve releases. This allowed Nortel to report nearly break-even results (though not actual profit) and to show internally that the company had again reached profitability on a pro forma basis necessary to pay bonuses.

Siemens Reserve

During the fraud trial, former Nortel accountant Susan Shaw testified about one of the most controversial accounting provisions on the company’s books, relating to a 2001 lawsuit filed against Nortel by Siemens AG. It was long-standing practice across Nortel to establish reserves on a “worst case” basis, which meant at an amount equal to the maximum possible exposure.

Nortel had created an accounting reserve on its books at the time the Siemens lawsuit was filed to provide for a settlement in the case, but it was alleged that a portion of the provision was arbitrarily left on Nortel’s books long after the lawsuit was resolved in the fourth quarter of 2001. It became part of a group of extra head office, non-operating reserves that allegedly was reversed arbitrarily—and with no appropriate business trigger—to push the company into a profit in 2003 and earn “return to profitability” bonuses for executives.

The $4-million remaining Siemens provision was initially booked to be reversed into income in the first quarter of 2003, but then withdrawn, allegedly because it was not needed to push the company into a profitable position in the quarter. It was then booked to be used in the second quarter, and became the only head office non-operating reserve used in the quarter.

The contention was that the Siemens reserve was used in that quarter because Nortel needed almost exactly $4 million more income to reach the payout trigger for the company’s restricted share unit plan at that time. However, lawyer David Porter argued the Siemens amount was triggered in the second quarter because that is when the company believed it was no longer needed and should appropriately be reversed.

In cross-examination, Porter showed Shaw a working document recovered from the files of Nortel’s external auditors at Deloitte & Touche, showing the auditor reviewed Nortel’s justifications for keeping the Siemens reserve on the books until that time and for reversing it in the second quarter of 2003. Deloitte’s notes showed the auditor reviewed Nortel’s detailed rationale for the reserve and concluded its release in the second quarter was “reasonable.”3

The company said it was holding on to the reserve because the settlement with Siemens had been “rancorous” and Nortel wanted to be sure there would be no further claims made after the lawsuit was settled and $32 million was paid to Siemens in two installments in late 2001 and late 2002.

In its working notes, Deloitte recorded that Nortel felt it was “prudent” to keep the $4 million on the books until mid-2002. Shaw testified she felt the reserve was being reversed on schedule with the plan to keep it in place for the first two quarters of the year. Porter asked Shaw whether the auditors were satisfied at the time there was an appropriate triggering event to use the reserve in the second quarter of 2002, and she replied there was one.

However, the amount became part of a broad restatement of reserves announced at Nortel at the end of 2003. The company noted in the restatement that the Siemens reserve should have been reversed in the fourth quarter of 2001 when the lawsuit was settled.

Role of Auditors and Audit Committee

In late October 2000, as a first step toward reintroducing bill-and-hold transactions into Nortel’s sales and accounting practices, Nortel’s then controller and assistant controller asked Deloitte to explain, among other things, (1) “[u]nder what circumstances can revenue be recognized on product (merchandise) that has not been shipped to the end customer?” and (2) whether merchandise accounting can be used to recognized revenues “when installation is imminent” or “when installation is considered to be a minor portion of the contract”?4

On November 2, 2000, Deloitte presented Nortel with a set of charts that, among other things, explained the US GAAP criteria for revenues to be recognized prior to delivery (including additional factors to consider for a bill-and-hold transaction) and also provided an example of a customer request for a bill-and-hold sale “that would support the assertion that Nortel should recognize revenue” prior to delivery.

Nortel’s earnings management scheme began to unravel at the end of the second quarter of 2003. On the morning of July 24, 2003, the same day on which Nortel issued its second Quarter 2003 earnings release, Deloitte informed Nortel’s audit committee that it had found a “reportable condition” with respect to weaknesses in Nortel’s accounting for the establishment and disposition of reserves. Deloitte went on to explain that, in response to its concerns, Nortel’s management had undertaken a project to gather support and determine proper resolution of certain provision balances. Management, in fact, had undertaken this project because the auditor required adequate audit evidence for the upcoming year-end 2003 audit. Nortel concealed its auditor’s concerns from the public, instead disclosing the comprehensive review.

Shortly after Nortel’s announced restatement, the audit committee commenced an independent investigation and hired outside counsel to help it “gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated,” as well as to recommend any necessary remedial measures. The investigation uncovered evidence that Dunn, Beatty, and Gollogly and certain other financial managers were responsible for Nortel’s improper use of reserves in the second half of 2002 and first half of 2003.

In March 2004, Nortel suspended Beatty and Gollogly and announced that it would “likely” need to revise and restate previously filed financial results further. Dunn, Beatty, and Gollogly were terminated for cause in April 2004.

On January 11, 2005, Nortel issued a second restatement that restated approximately $3.4 billion in misstated revenues and at least another $746 million in liabilities. All of the financial statement effects of the defendants’ two accounting fraud schemes were corrected as of this date, but there remained lingering effects from the defendants’ internal control and other nonfraud violations.

Nortel also disclosed the findings to date of the audit committee’s independent review, which concluded, among other things, that Dunn, Beatty, and Gollogly were responsible for Nortel’s improper use of reserves in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that Nortel’s top executives had also engaged in revenue recognition fraud in 2000.

In May 2006, in its Form 10-K for the period ending December 31, 2005, Nortel admitted for the first time that its restated revenues in part had resulted from management fraud, stating that “in an effort to meet internal and external targets, the senior corporate finance management team . . . changed the accounting policies of the company several times during 2000,” and that those changes were “driven by the need to close revenue and earnings gaps.”

Throughout their scheme, the defendants lied to Nortel’s independent auditor by making materially false and misleading statements and omissions in connection with the quarterly reviews and annual audits of the financial statements that were materially misstated. Among other things, each of the defendants submitted management representation letters to the auditors that concealed the fraud and made false statements, which included that the affected quarterly and annual financial statements were presented in conformity with U.S. GAAP and that they had no knowledge of any fraud that could have a material effect on the financial statements. Dunn, Beatty, and Gollogly also submitted a false management representation letter in connection with Nortel’s first restatement, and Pahapill likewise made false management representations in connection with Nortel’s second restatement.

The defendants’ scheme resulted in Nortel issuing materially false and misleading quarterly and annual financial statements and related disclosures for at least the financial reporting periods ending December 31, 2000, through December 31, 2003, and in all subsequent filings made with the SEC that incorporated those financial statements and related disclosures by reference.

On October 15, 2007, Nortel, without admitting or denying the SEC’s charges, agreed to settle the commission’s action by consenting to be enjoined permanently from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws and by paying a $35 million civil penalty, which the commission placed in a Fair Fund5 for distribution to affected shareholders.6 Nortel also agreed to report periodically to the commission’s staff on its progress in implementing remedial measures and resolving an outstanding material weakness over its revenue recognition procedures.

On January 14, 2009, Nortel filed for protection from creditors in the United States, Canada, and the United Kingdom in order to restructure its debt and financial obligations. In June, the company announced that it no longer planned to continue operations and that it would sell off all of its business units. Nortel’s CDMA wireless business and long-term evolutionary access technology (LTE) were sold to Ericsson, and Avaya purchased its Enterprise business unit.

The final indignity for Nortel came on June 25, 2009, when Nortel’s stock price dropped to 18.5¢ a share, down from a high of $124.50 in 2000. Nortel’s battered and bruised stock was finally delisted from the S&P/TSX composite index, a stock index for the Canadian equity market, ending a colossal collapse on an exchange on which the Canadian telecommunications giant’s stock valuation once accounted for a third of its value.

Postscript

The three former top executives of Nortel Networks Corp. were found not guilty of fraud on January 14, 2013. In the court ruling, Justice Frank Marrocco of the Ontario Superior Court found that the accounting manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into criminal behavior.

Accounting experts said the case is sure to be closely watched by others in the business community for the message it sends about where the line lies between fraud and the acceptable use of discretion in accounting.

The decision underlines that management still has a duty to prepare financial statements that “present fairly the financial position and results of the company” according to a forensic accountant, Charles Smedmor, who followed the case. “Nothing in the judge’s decision diminished that duty.”

During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by Nortel’s auditors from Deloitte & Touche. Judge Marrocco accepted these arguments, noting many times in his ruling that bookkeeping decisions were reviewed and approved by auditors and were disclosed adequately to investors in press releases or notes added to the financial statements.

Nonetheless, the judge also said that he believed that the accused were attempting to “manage” Nortel’s financial results in both the fourth quarter of 2002 and in 2003, but he added he was not satisfied that the changes resulted in material misrepresentations. He said that except for $80 million of reserves released in the first quarter of 2003, the rest of the use of reserves was within “the normal course of business.” Judge Marrocco said the $80 million release, while clearly “unsupportable” and later reversed during a restatement of Nortel’s books, was disclosed properly in Nortel’s financial statements at the time and was not a material amount. He concluded that Beatty and Dunn “were prepared to go to considerable lengths” to use reserves to improve the bottom line in the second quarter of 2003, but he said the decision was reversed before the financial statements were completed because Gollogly challenged it.

In a surprising twist, Judge Marrocco also suggested the two devastating restatements of Nortel’s books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood why they were done in the context of the time. He said the original statements were arguably correct within a threshold of what was material for a company of that size.

Darren Henderson, an accounting professor at the Richard Ivey School of Business at the University of Western Ontario, said that a guilty verdict would have raised the bar for management to justify their accounting judgments. But the acquittal makes it clear that “management manipulation of financial statements is very difficult to prove beyond a reasonable doubt in a court of law,” he said.

It is clear that setting up reserves or provisions is still subject to management discretion, Henderson said. “The message . . . is that it is okay to use accounting judgments to achieve desired outcomes, [such as] a certain earnings target.”

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 – 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 “expected” 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.

Pete Slokowsky and Mary Jackson 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 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 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

2,140,000

4

3,100,000

5

3,100,000

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.

Pete and Mary 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 $ 4,500,000. After taking into account the sale of their patent, the net investment would be $4,200,000. As for the future, Mary and Pete 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

(4,200,000)

1

2,500,000

2

2,000,000

3

905,000

4

550,000

5

250,000

Mary and Pete 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)

3.58

1.85

Discounted payback period (in years)

4.64

2.86

Net Present Value (NPV)

$556,306

$520,011

Internal Rate of Return (IRR)

18.35%

22.51%

Profitability Index

1.11

1.12

Modified Internal Rate of Return (MIRR)

17.45%

17.72%

One of the concerns that Mary and Pete 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 Pete and Mary 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:

1.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?

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

2.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?

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

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

b) Mary believes that the best approach to make the decision is the NPV approach. However, Pete 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.

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

4.a) Which of these projects would you recommend? Explain why.

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