Explanation 1

Mike and Joan wants to set up a venture of thier own and have following 2 ideas:

1) They have developed a new design of the chip which could speed up certain specialized tasks by as
much as 25%, however the design of the chip was not complete and they want further experimentation
that may improve the performance of their design. They have project cash flows relating to this project
including the initial cash outflow on plant and equipment and resulting cash flows over 5 years, the life
of the project. Post 5 years, they can sold the intial plant and equimpment purchased.

2) On the other hand, if they do not want to pursue Opportunity 1, they could sold the innovative chip
design to one of the established chip makers and could then invest in some plant and equipment that
would test silicon wafers for zircon content before the wafers were used to make chips. Mike and Joan
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. They have project cash flows relating
to this project including the initial cash outflow on plant and equipment and resulting cash flows over 5
years, the life of the project.

Mike and Joan would like to evaluate which one of the 2 opportunities they should go after and which
could given them maximum benefit
 2 ideas:

ertain specialized tasks by as

want further experimentation
h flows relating to this project
ash flows over 5 years, the life
t purchased.

ould sold the innovative chip

me plant and equipment that
to make chips. Mike and Joan
to outsource this function to
be able to slash costs by more
y check for roughly the same
ave project cash flows relating
and resulting cash flows over 5

ey should go after and which

Explanation 2

One of the only ways to evaluate such ideas is by using the Discounted Cash Flow approach. Such idea
are best evaluated by using Discounted Cash Flow approach as it gives the real picture as against the
unreal picture of accounting profits.

Cash is the true measure of success and not profits due to time value of money.

Some of the critera or metrics that can be used to help make the decisions are as follows:

1) Net Present Value - This method tells us total value that will be added to the stakeholder's wealth
upon acceptance of any project and is the most important criteria. Higher the NPV the better.
2) Internal Rate of Return - This tells us the actual rate of return being earned on the project. Only
projects having internal rate of return higher than the cost of capital should be accepted. Higher the
internal rate of return the better.
3) Pay back period - This tell us in absolute terms within how many years the investment will be reaped
back. The faster the investment is reaped back, the better. Lower the Pay back period, the better.
4) Discounted payback period - This is more accurate that payback period as it takes into account the
timing of cash flows as well while calculating the payback period. Lower the discounted payback perio
time, the better.
5) Profitability Index - Higher the profitability index the better, as it measures the amount of cash
inflows per $ of cash outflows
Cash Flow approach. Such ideas
he real picture as against the

money.

s are as follows:

to the stakeholder's wealth

the NPV the better.
rned on the project. Only
ld be accepted. Higher the

s the investment will be reaped

back period, the better.
d as it takes into account the
r the discounted payback period

sures the amount of cash

Explanation 3a

Payback period (in years) Project Project

A B
Payback period (in years) 3.15 1.38
Ranking II I
Discounted payback period (in 3.98 1.79
years)
Ranking II I
Net Present Value (NPV) $612,847 $596,206

Ranking I II
Internal Rate of Return (IRR) 35.93% 55.07%
Ranking II I
Profitability Index 1.61 1.66
Ranking II I
Modified Internal Rate of Return 32.04% 32.84%
(MIRR)
Ranking II I

Explanation 3b

It is clearly mentioned in the question that for the purpose of evaluating the investment, Mike and Joan
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.

Both Project A and Project B meet the above criterias. Both of the projects have IRR higher than 20%,
both of the projects have a payback period of less than 3.5 years and both of the projects have
discounted payback period of less than 4 years.

Generally when projects are mutually exclusive, it is best to be decided in favour of that project which
has the highest Net Present Value.Net Present Value is the most important criteria in determining which
project to choose, as the net present value is the real increase in value to the wealth of the stakeholders.

However, we should be mindful of the fact that Net Present Value relies heavily on the quantum of cash
flows and the timing of the cash flows, and slightest mistake in evaluating quantum of cash flows and
the timing of cash flows, can lead to analysts taking a wrong decision.

In the present case, even though the Net Present Value is higher for Project A at $612847 as compared
to Project B at $596206, however, one very important factot to be considered is majority of the cash
flows for Project A comes at Year 4 and 5 whereas majority of the cash flow for Project B comes at Yea
1,2 and 3
In the present case, even though the Net Present Value is higher for Project A at $612847 as compared
to Project B at $596206, however, one very important factot to be considered is majority of the cash
flows for Project A comes at Year 4 and 5 whereas majority of the cash flow for Project B comes at Yea
1,2 and 3
he investment, Mike and Joan
y would prefer that the project
d payback period of less than 4

ts have IRR higher than 20%,

h of the projects have

n favour of that project which

t criteria in determining which
the wealth of the stakeholders.

heavily on the quantum of cash

g quantum of cash flows and

ct A at $612847 as compared
ered is majority of the cash
ow for Project B comes at Year
Explanation 4a

Even though the Net Present Value criteria indicates acceptance of Project A, however I would go for
the acceptance of Project B. This is simply because of the fact that Project B has much lower payback
period, much lower discounted payback period, higher Internal Rate of Return and higher profitability
index, where as the difference in Net Present Value is not much significant as compared to Project A.

Considering Mike and Joan are pretty sure that there would be sizable profits in the first couple of years
for Project B, hence it would be best to go for Project B

Limitations of this approach are as follows:

1) Project B primarily has lower payback period/ discounted payback period and higher Internal Rate o
Return due to receipt of higher cash flows at the start of the project. One has to very critically evaluate
the cash flow numbers of Project B to be sure that the estimated cash flows are realistic else the
decision of going with Project B may turn out to be a wrong one.

2) Analysis on whethe the chip makers would be willing to go for 100% quality check for silicon
wafers. If it turns out that the chip makers are not very enthusiastic about 100% quality check and are
doing reasonably good business, then there is huge risk to estimated cash flow projections.

3)
ct A, however I would go for
ct B has much lower payback
Return and higher profitability
nt as compared to Project A.

ofits in the first couple of years

riod and higher Internal Rate of

has to very critically evaluate
ws are realistic else the

quality check for silicon

100% quality check and are
flow projections.