Charles and Caitlinare facing an important decision. After having discussed differentfinancial scenarios, the two computer engineers felt it was time tofinalize their cash flow projections and move to the next stage –decide which of two possible projects they should undertake.

Both had a bachelordegree in engineering and had put in several years as maintenanceengineers in a large chip manufacturing company. About six monthsago, they were able to exercise their first stock options. That waswhen they decided to quit their safe, steady job and pursue theirdreams of starting a venture of their own. In their spare time,almost as a hobby, they had been collaborating on some researchinto a new chip that could speed up certain specialized tasks by asmuch as 25%. At this point, the design of the chip was complete.While further experimentation might improve the performance oftheir design, any delay in entering the market now may prove to becostly, as one of the established players might introduce a similarproduct of their own. The duo knew that now was the time to act ifat all.

They estimated thatthey would need to spend about $1,000,000 on plant, equipment andsupplies. As for future cash flows, they felt that the rightstrategy at least for the first year would be to sell their productat dirt-cheap prices in order to induce customer acceptance. Then,once the product had established a name for itself, the price couldbe raised. By the end of the fifth year, their product in itscurrent form was likely to be obsolete. However, the innovativeapproach that they had devised and patented could be sold to alarger chip manufacturer for a decent sum. Accordingly, the twobudding entrepreneurs estimated the operating cash flows for thisproject (call it Project A) as follows:

PROJECTA                                                                                                 

YEAR	0	1	2	3	4
Expected CFs ($)	-1,000,000	50,000	200,000	600,000	1,000,000

An alternative topursuing this project would be to sell their innovative chip designto one of the established chip makers. This way, they would receivean upfront payment. But the amount would be relatively small –perhaps around $200,000 – as neither their product nor theirinnovative approach had a track record.

They could theninvest in some plant and equipment that would test silicon wafersfor zircon content before the wafers were used to make chips. Toomuch zircon would affect the long-term performance of the chips.The task of checking the level of zircon was currently beingperformed by chip makers themselves. However, many of them,especially the smaller ones, did not have the capacity to permit100% checking. Most tested only a sample of the wafers theyreceived. Dave and Eva were confident that they could persuade atleast some of the chip makers to outsource this function to them.By exclusively specializing in this task, their little companywould be able to slash costs by more than half, and thus allow thechip manufacturers to go in for 100% quality check for roughly thesame cost as what they were incurring for a partial quality checktoday. The life of this project too is expected to be only aboutfive years. The initial investment for this project is estimated at$ 1,100,000. After taking into account the sale of their patent,the net investment would be $900,000. As for the future, Charlesand Caitlin were pretty sure that there would be sizable profits inthe first year. But thereafter, the zircon content problem wouldslowly start to disappear with advancing technology in the waferindustry.

Keeping this inmind, they estimate the future cash inflows for this project (callit Project B) as follows:

PROJECTB                                                                                                 

YEAR	0	1	2	3	4
Expected CFs ($)	-900,000	650,000	650,000	550,000	300,000

Charles and Caitlinnow need to make their decision. For purposes of analysis, theyplan to use a required rate of return of 20% for both projects.Ideally, they would prefer that the project they choose have apayback period of less than 3.5 years and a discounted paybackperiod of less than 4 years.

One of the concernsthat Charles and Caitlin have is regarding the reliability of theircash flow estimates. The analysis depends on the accuracy of thoseprojected cash flows. However, they are both aware that actualfuture cash flows may be higher or lower.

QUESTION  

1. Which of these projects would you recommend? Explainwhy.