Investment Decision Analysis: Project A vs. Project B

QUESTION

Case study-2

Dan and Susan are facing an important decision. After having discussed different financial scenarios, 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 $1,000,000 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:

Project A

Year Expected Cash flows ($)

0 (1,000,000)

1 40,000

2 200,000

3 500,000

4 1,000,000

5 1,300,000

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 $200,000 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.

Dan and Susan 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 $ 1,100,000. After taking into account the sale of their patent, the net investment would be $900,000. As for the future, Dan and Susan 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:

Project B

Year Expected Cash flows ($)

0 ($900,000)

1 750,000

2 600,000

3 500,000

4 400,000

5 200,000

Dan and Susan now need to make their decision. For purposes of analysis, they plan to use a required rate of return of 20% 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.

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Evaluate both the projects based on NPV, Pay back and discounted payback and Mention the most feasible project to invest as per the above mentioned techniques.

ANSWER

Investment Decision Analysis: Project A vs. Project B

Introduction

Dan and Susan, two computer engineers with a dream to start their venture, face a critical decision between two projects: Project A, which involves launching an innovative chip, and Project B, which focuses on testing silicon wafers for zircon content. To make an informed choice, the duo plans to evaluate both projects using three crucial financial techniques: Net Present Value (NPV), Payback Period, and Discounted Payback Period. The projects will be analyzed with a required rate of return of 20%, and the goal is to find the most feasible investment option that aligns with their preference for a payback period of less than 3.5 years and a discounted payback period of less than 4 years.

Net Present Value (NPV) Analysis

Project A:
NPV is calculated by finding the present value of future cash flows and subtracting the initial investment. Using a 20% discount rate, we compute the NPV for Project A as follows:

NPV_A = (40,000 / (1 + 0.20)^1) + (200,000 / (1 + 0.20)^2) + (500,000 / (1 + 0.20)^3) + (1,000,000 / (1 + 0.20)^4) + (1,300,000 / (1 + 0.20)^5) – 1,000,000

NPV_A ≈ $846,275.92

Project B:
Similarly, we calculate the NPV for Project B:

NPV_B = (750,000 / (1 + 0.20)^1) + (600,000 / (1 + 0.20)^2) + (500,000 / (1 + 0.20)^3) + (400,000 / (1 + 0.20)^4) + (200,000 / (1 + 0.20)^5) – 900,000

NPV_B ≈ $706,611.57

Payback Period Analysis:

Project A:
The payback period is the time taken to recoup the initial investment. To find the payback period for Project A, we calculate:

Payback_A = 1 + [(1,000,000 – 40,000) / 200,000] = 5.3 years

Project B:
For Project B, the payback period is:

Payback_B = 1 + [(900,000 – 750,000) / 600,000] = 2.25 years

Discounted Payback Period Analysis:

Project A:
The discounted payback period accounts for the time required to recover the initial investment using discounted cash flows. We calculate:

Discounted_Payback_A = 1 + [(1,000,000 – (40,000 / (1 + 0.20)^1) – (200,000 / (1 + 0.20)^2)) / (500,000 / (1 + 0.20)^3)]

Discounted_Payback_A ≈ 4.38 years

Project B:
The discounted payback period for Project B is:

Discounted_Payback_B = 1 + [(900,000 – (750,000 / (1 + 0.20)^1)) / ((600,000 / (1 + 0.20)^2))]

Discounted_Payback_B ≈ 2.63 years

Conclusion

Based on the financial analysis using NPV, payback period, and discounted payback period, we find that both Project A and Project B show promising results. Project A has a higher NPV ($846,275.92) compared to Project B ($706,611.57). However, Project B outperforms Project A in terms of both payback period (2.25 years) and discounted payback period (2.63 years), meeting the entrepreneurs’ preference for shorter payback periods.

Considering the focus on payback periods and discounted payback periods, Project B emerges as the most feasible investment option for Dan and Susan. Its shorter payback periods suggest that they will recoup their initial investment quicker, allowing for a faster recovery of capital and reduced risk. Moreover, the opportunity to capitalize on a niche market by offering specialized services gives Project B a competitive edge.

In conclusion, Project B, with its favorable financial outcomes and shorter payback periods, appears to be the more viable choice for Dan and Susan’s investment. However, the entrepreneurs should also consider non-financial factors, such as their expertise, passion, and long-term vision, before making the final decision to ensure the project aligns with their overall goals.