Charles and Caitlin are facing an important decision. Afterhaving discussed different financial scenarios, the two computerengineers felt it was time to finalize their cash flow projectionsand move to the next stage – decide which of two possible projectsthey should undertake. Both had a bachelor degree in engineeringand had put in several years as maintenance engineers in a largechip manufacturing company. About six months ago, they were able toexercise their first stock options. That was when they decided toquit their safe, steady job and pursue their dreams of starting aventure of their own. In their spare time, almost as a hobby, theyhad been collaborating on some research into a new chip that couldspeed up certain specialized tasks by as much as 25%. At thispoint, the design of the chip was complete. While furtherexperimentation might improve the performance of their design, anydelay in entering the market now may prove to be costly, as one ofthe established players might introduce a similar product of theirown. The duo knew that now was the time to act if at all. Theyestimated that they would need to spend about $1,000,000 on plant,equipment and supplies. As for future cash flows, they felt thatthe right strategy at least for the first year would be to selltheir 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 operatingcash flows for this project (call it Project A) as follows:

PROJECT A YEAR 0 1 2 3 4 Expected CFs ($) -1,000,000 50,000200,000 600,000 1,000,000 An alternative to pursuing this projectwould be to sell their innovative chip design to one of theestablished chip makers. This way, they would receive an upfrontpayment. But the amount would be relatively small – perhaps around$200,000 – as neither their product nor their innovative approachhad a track record. They could then invest in some plant andequipment that would test silicon wafers for zircon content beforethe wafers were used to make chips. Too much zircon would affectthe long-term performance of the chips. The task of checking thelevel of zircon was currently being performed by chip makersthemselves. However, many of them, especially the smaller ones, didnot have the capacity to permit 100% checking. Most tested only asample of the wafers they received. Dave and Eva were confidentthat they California State University | Monterey Bay could persuadeat least some of the chip makers to outsource this function tothem. By exclusively specializing in this task, their littlecompany would be able to slash costs by more than half, and thusallow the chip manufacturers to go in for 100% quality check forroughly the same cost as what they were incurring for a partialquality check today. The life of this project too is expected to beonly about five years. The initial investment for this project isestimated at $ 1,100,000. After taking into account the sale oftheir patent, the net investment would be $900,000. As for thefuture, Charles and Caitlin were pretty sure that there would besizable profits in the first year. But thereafter, the zirconcontent problem would slowly start to disappear with advancingtechnology in the wafer industry. Keeping this in mind, theyestimate the future cash inflows for this project (call it ProjectB) as follows:

PROJECT B YEAR 0 1 2 3 4 Expected CFs ($) -900,000 650,000650,000 550,000 300,000 Charles and Caitlin now need to make theirdecision. For purposes of analysis, they plan to use a requiredrate of return of 20% for both projects. Ideally, they would preferthat the project they choose have a payback period of less than 3.5years and a discounted payback period of less than 4 years. One ofthe concerns that Charles and Caitlin have is regarding thereliability of their cash flow estimates. The analysis depends onthe accuracy of those projected cash flows. However, they are bothaware that actual future cash flows may be higher or lower.

ASSIGNMENT QUESTIONS

1. Rank the projects based on each of the following metrics:Payback period, Discounted payback period, NPV, IRR, ProfitabilityIndex.

2. Charles believes that the best approach to make the decisionis the NPV approach. However, Caitlin is not so sure that ignoringthe other metrics is a good idea. Which of the approaches ormetrics would you propose? In other words, would you prefer one ormore of these approaches over the others? Explain why.

3. Which of these projects would you recommend? Explain why.

4. Briefly state the limitations of the approach you used inmaking this decision, and outline what further analysis you wouldrecommend.