BioCom was founded in 1993, when several scientists and engineers at a large fiber-optic-cable company began to see that optical fiber for the telecommunications industry was becoming a cheap commodity. They decided to start their own firm, which would specialize in cutting-edge applications for research in the life sciences and medical instruments. BioCom is now one of the leading firms in its niche field. BioComs management attributes the firms success to its ability to stay one step ahead of the markets fast-changing technological needs. Almost as important is BioComs ability to select high-value-added projects and avoid commercial disasters. Over lunch, BioComs director of research and development (R&D) mentioned to the CFO that one of his best young scientists had recently left the company because his line manager had rejected his project. Although not a pattern, R&D had experienced similar losses in the past. The two executives discussed the problem and agreed that if the R&D people understood the selection process better, they might come up with more commercially viable projects and understand the projects financial implications. The CFO then asked his assistant, Jane Donato, to prepare a retreat for the R&D department to explain the companys project selection procedures. Jane is encouraged by the thought that this group will have no trouble in following the math!

Cash Flow Nano Test Tubes. Microsurgery Kits

Investment -$11,000 -$11,000

Cash flow year 1 $2,000 $4,000

Cash flow year 2 $3,000 $4,000

Cash flow year 3 $4,000 $4,000

Cash flow year 4 $5,000 $4,000

Cash flow year 5 $7,000 $4,000

BioComs standard capital request form includes a narrative description of the project and the customer need that the company must fulfill. If the request originates with R&D, it then goes to the marketing department for a preliminary sales forecast and then to the production manager and cost analysts for cost estimates. If a proposal shows promise after these steps, it goes to the CFO, who has a staff member enter the data into a spreadsheet template. The template computes payback, discounted payback, net present value and internal rate of return. BioCom uses net present value as its primary decision criterion, but company executives believe that the other metrics provide some useful additional perspectives. To explain BioComs capital budgeting techniques, Jane has decided to present the cash flows from two recent proposals: the nano test tube project and the microsurgery kit project. All figures are in thousands of dollars: Help Jane answer the following questions. Questions

1. Compute the payback period for each project.

a. Explain the rationale behind the payback method.

b. State and explain the decision rule for the payback method.

c. Explain how the company would use the payback method to rank mutually exclusive projects.

d. Comment on the advantages and shortcomings of this method.

2. Compute the discounted payback period for each project using a discount rate of 10%.

a. Explain the rationale behind the discounted payback method.

b. State and explain the decision rule for the discounted payback method.

c. Explain how the company would use the discounted payback method to rank mutually exclusive projects.

d. Comment on the advantages and shortcomings of this method.

3. Compute the net present value for each project. BioCom uses a discount rate of 9% for projects of average risk.

a. Explain the rationale behind the NPV method.

b. State and explain the decision rule for the NPV method.

c. Explain how the company would use the NPV method to rank mutually exclusive projects.

d. Comment on the advantages and shortcomings of this method.

4. Compute the internal rate of return for each project.

a. Explain the rationale behind the IRR method.

b. State and explain the decision rule for the IRR method. Assume a WACC of 9%.

c. Explain how the company would use the IRR method to rank mutually exclusive projects.

d. Comment on the advantages and shortcomings of this method.

5. Explain to the R&D staff why BioCom uses the NPV method as its primary project selection criterion.