Maya Lee and John Spencer are facing an important decision.After having discussed different financial scenarios into the weehours of the morning, the two computer engineers felt it was timeto finalize their cash flow projections and move to the next stage– decide which of two possible projects they should undertake. Bothhad a bachelor degree in engineering and had put in several yearsas maintenance engineers in a large chip manufacturing company.About six months ago, they were able to exercise their first stockoptions. That was when they decided to quit their safe, steady joband pursue their dreams of starting a venture of their own. Intheir spare time, almost as a hobby, they had been collaborating onsome research into a new chip that could speed up certainspecialized tasks by as much as 25%. At this point, the design ofthe chip was complete. While further experimentation might improvethe performance of their design, any delay in entering the marketnow may prove to be costly, as one of the established players mightintroduce a similar product of their own. The duo knew that now wasthe time to act if at all. They estimated that they would need tospend about $2,500,000 on plant, equipment and supplies. As forfuture cash flows, they felt that the right strategy at least forthe first year would be to sell their product at dirt-cheap pricesin order to induce customer acceptance. Then, once the product hadestablished a name for itself, the price could be raised. By theend of the fifth year, their product in its current form was likelyto be obsolete. However, the innovative approach that they haddevised and patented could be sold to a larger chip manufacturerfor a decent sum. Accordingly, the two budding entrepreneursestimated the cash flows for this project (call it Project A) asfollows: Year Project A Expected Cash flows ($) 0 ($2,500,000) 1$290,000 2 $400,000 3 $880,000 4 $1,600,000 5 $1,600,000 Analternative to pursuing this project would be to immediately sellthe 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 plantand equipment that would test silicon wafers for zircon contentbefore the wafers were used to make chips. Too much zircon wouldaffect the long-term performance of the chips. The task of checkingthe level 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. Maya and John were confidentthat they could persuade at least some of the chip makers tooutsource this function to them. By exclusively specializing inthis task, their little company would be able to slash costs bymore than half, and thus allow the chip manufacturers to go in for100% quality check for roughly the same cost as what they wereincurring for a partial quality check today. The life of thisproject too (call it project B) is expected to be only about fiveyears. The initial investment for this project is estimated at $2,600,000. After taking into account the sale of their patent, thenet investment would be $2,400,000. As for the future, Maya andJohn were reasonably sure that there would be sizable profits inthe first couple of years. But thereafter, the zircon contentproblem would slowly start to disappear with advancing technologyin the wafer industry. Keeping all this in mind, they estimate thecash flows for this project as follows: Year Project B ExpectedCash flows ($) 0 ($2,400,000) 1 $1,450,000 2 $1,215,000 3 $470,0004 $285,000 5 $165,000 Maya and John now need to make theirdecision. For purposes of analysis, they plan to use a requiredrate of return of 15% for both projects. Ideally, they would preferthat the project they choose have a payback period of less than 4years and a discounted payback period of less than 5 years. Beloware the results of the analysis they have carried out so far:Metrics Project A Project B Payback period (in years) 3.58 1.78Discounted payback period (in years) 4.57 2.71 Net Present Value(NPV) $343,534 $333,601 Internal Rate of Return (IRR) 19.22% 23.50%Profitability Index 1.1374 1.1390 Modified Internal Rate of Return(MIRR) 18.00% 18.03% One of the concerns that Maya and John have isregarding the reliability of their cash flow estimates. All theanalysis in the table above is based on “expected” cash flows.However, they are both aware that actual future cash flows may behigher or lower. Assignment: Suppose that Maya and John have hiredyou as a consultant to help them make the decision. Please draft anofficial memo to them with your analysis and recommendations.
1. 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?

2. What are some approaches that can be used to solve thisproblem? What are some various criteria or metrics that can be usedto help make this decision?

3. a) Rank the projects based on each of the following metrics:Payback period, Discounted payback period, NPV, IRR, ProfitabilityIndex, and MIRR. b) John believes that the best approach to makethe decision is the NPV approach. However, Maya is not so sure thatignoring the other metrics is a good idea. Which of the approachesor metrics would you propose? In other words, would you prefer oneor more of these approaches over the others? Explain why.

4. a) Which of these projects would you recommend? Explain why.b) Briefly state the limitations of the approach you used in makingthis decision, and outline what further analysis you wouldrecommend.