Capital Budgeting Case Study
Instructions: The assignment is based onthe case below. The instruction relating to the assignment is atthe end of the case.
Dan and Susan are facing an important decision. After havingdiscussed different financial scenarios, the two computer engineersfelt it was time to finalize their cash flow projections and moveto the next stage â decide which of two possible projects theyshould undertake.
Both had a bachelor degree in engineering and had put in severalyears as maintenance engineers in a large chip manufacturingcompany. About six months ago, they were able to exercise theirfirst stock options. That was when they decided to quit their safe,steady job and pursue their dreams of starting a venture of theirown. In their spare time, almost as a hobby, they had beencollaborating on some research into a new chip that could speed upcertain specialized tasks by as much as 25%. At this point, thedesign of the chip was complete. While further experimentationmight improve the performance of their design, any delay inentering the market now may prove to be costly, as one of theestablished 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 $1,000,000 onplant, equipment and supplies. As for future cash flows, they feltthat the right strategy at least for the first year would be tosell their product at dirt-cheap prices in order to induce customeracceptance. Then, once the product had established a name foritself, the price could be raised. By the end of the fifth year,their product in its current form was likely to be obsolete.However, the innovative approach that they had devised and patentedcould be sold to a larger chip manufacturer for a decent sum.Accordingly, the two budding entrepreneurs estimated the cash flowsfor this project (call it Project A) as follows:
Year
Project A
Expected Cash flows ($)
0
(1,000,000)
1
50,000
2
200,000
3
600,000
4
1,000,000
5
1,500,000
An alternative to pursuing this project would be to immediatelysell the patent for their innovative chip design to one of theestablished chip makers. They estimated that they would receivearound $200,000 for this. It would probably not be reasonable toexpect much more as neither their product nor their innovativeapproach had a track record.
They could then invest in some plant and equipment that wouldtest silicon wafers for zircon content before the wafers were usedto make chips. Too much zircon would affect the long-termperformance of the chips. The task of checking the level of zirconwas currently being performed by chip makers themselves. However,many of them, especially the smaller ones, did not have thecapacity to permit 100% checking. Most tested only a sample of thewafers they received.
Dan and Susan were confident that they could persuade at leastsome of the chip makers to outsource this function to them. Byexclusively specializing in this task, their little company wouldbe able to slash costs by more than half, and thus allow the chipmanufacturers to go in for 100% quality check for roughly the samecost as what they were incurring for a partial quality check today.The life of this project too (call it project B) is expected to beonly about five years.
The initial investment for this project is estimated at $1,100,000. After taking into account the sale of their patent, thenet investment would be $900,000. As for the future, Dan and Susanwere pretty sure that there would be sizable profits in the firstcouple of years. But thereafter, the zircon content problem wouldslowly start to disappear with advancing technology in the waferindustry. Keeping all this in mind, they estimate the cash flowsfor this project as follows:
Year
Project B
Expected Cash flows ($)
0
($900,000)
1
650,000
2
650,000
3
550,000
4
300,000
5
100,000
Dan and Susan now need to make their decision. For purposes ofanalysis, they plan to use a required rate of return of 20% forboth projects. Ideally, they would prefer that the project theychoose have a payback period of less than 3.5 years and adiscounted payback period of less than 4 years.
Assignment:
Suppose that Dan and Susan have hired you as a consultant tohelp them make the decision. Please create an official presentationto present your findings and recommendations. The questions belowshould help to guide your insight.
Briefly, summarize the key facts of the case and identify theproblem being faced by our two budding entrepreneurs. In otherwords, what is the decision that they need to make? (10 points)
An excellent presentation will demonstrate the ability toconstruct a clear and insightful problem statement whileidentifying all underlying issues.
What are some approaches that can be used to solve this problem?What are various criteria or metrics that can be used to help makethis decision?
An excellent presentation will propose solutions that aresensitive to all the identified issues.
Capital Budgeting Case Study
Instructions: The assignment is based onthe case below. The instruction relating to the assignment is atthe end of the case.
Dan and Susan are facing an important decision. After havingdiscussed different financial scenarios, the two computer engineersfelt it was time to finalize their cash flow projections and moveto the next stage â decide which of two possible projects theyshould undertake.
Both had a bachelor degree in engineering and had put in severalyears as maintenance engineers in a large chip manufacturingcompany. About six months ago, they were able to exercise theirfirst stock options. That was when they decided to quit their safe,steady job and pursue their dreams of starting a venture of theirown. In their spare time, almost as a hobby, they had beencollaborating on some research into a new chip that could speed upcertain specialized tasks by as much as 25%. At this point, thedesign of the chip was complete. While further experimentationmight improve the performance of their design, any delay inentering the market now may prove to be costly, as one of theestablished 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 $1,000,000 onplant, equipment and supplies. As for future cash flows, they feltthat the right strategy at least for the first year would be tosell their product at dirt-cheap prices in order to induce customeracceptance. Then, once the product had established a name foritself, the price could be raised. By the end of the fifth year,their product in its current form was likely to be obsolete.However, the innovative approach that they had devised and patentedcould be sold to a larger chip manufacturer for a decent sum.Accordingly, the two budding entrepreneurs estimated the cash flowsfor this project (call it Project A) as follows:
Year | Project A Expected Cash flows ($) |
0 | (1,000,000) |
1 | 50,000 |
2 | 200,000 |
3 | 600,000 |
4 | 1,000,000 |
5 | 1,500,000 |
An alternative to pursuing this project would be to immediatelysell the patent for their innovative chip design to one of theestablished chip makers. They estimated that they would receivearound $200,000 for this. It would probably not be reasonable toexpect much more as neither their product nor their innovativeapproach had a track record.
They could then invest in some plant and equipment that wouldtest silicon wafers for zircon content before the wafers were usedto make chips. Too much zircon would affect the long-termperformance of the chips. The task of checking the level of zirconwas currently being performed by chip makers themselves. However,many of them, especially the smaller ones, did not have thecapacity to permit 100% checking. Most tested only a sample of thewafers they received.
Dan and Susan were confident that they could persuade at leastsome of the chip makers to outsource this function to them. Byexclusively specializing in this task, their little company wouldbe able to slash costs by more than half, and thus allow the chipmanufacturers to go in for 100% quality check for roughly the samecost as what they were incurring for a partial quality check today.The life of this project too (call it project B) is expected to beonly about five years.
The initial investment for this project is estimated at $1,100,000. After taking into account the sale of their patent, thenet investment would be $900,000. As for the future, Dan and Susanwere pretty sure that there would be sizable profits in the firstcouple of years. But thereafter, the zircon content problem wouldslowly start to disappear with advancing technology in the waferindustry. Keeping all this in mind, they estimate the cash flowsfor this project as follows:
Year | Project B Expected Cash flows ($) |
0 | ($900,000) |
1 | 650,000 |
2 | 650,000 |
3 | 550,000 |
4 | 300,000 |
5 | 100,000 |
Dan and Susan now need to make their decision. For purposes ofanalysis, they plan to use a required rate of return of 20% forboth projects. Ideally, they would prefer that the project theychoose have a payback period of less than 3.5 years and adiscounted payback period of less than 4 years.
Assignment:
Suppose that Dan and Susan have hired you as a consultant tohelp them make the decision. Please create an official presentationto present your findings and recommendations. The questions belowshould help to guide your insight.
Briefly, summarize the key facts of the case and identify theproblem being faced by our two budding entrepreneurs. In otherwords, what is the decision that they need to make? (10 points)
An excellent presentation will demonstrate the ability toconstruct a clear and insightful problem statement whileidentifying all underlying issues.
What are some approaches that can be used to solve this problem?What are various criteria or metrics that can be used to help makethis decision?
An excellent presentation will propose solutions that aresensitive to all the identified issues.
