Lester was given significant stock options in the company and was told that he was expected to return the firms lost luster. At the last annual meeting there had been some debate among the key owners concerning the firms underlying philosophy. The more aggressive ones (e.g. hedge fund) wanted the company to take more chances, while the conservative parties preferred a cautious approach. The issue was never resolved, and Lester concluded that he could decide the risk posture of the firm for himself. Lester was certain that his own position would be on solid ground if he followed a high-risk, high-return policy-and was successful. His stock options under these conditions would be extremely valuable, and his salary would be assured. He also knew that he would be out of a job if he followed such a policy and the company was not successful. On the other hand, he was not altogether sure what his position would be if he followed a conservative policy. The company could survive and earn a modest profit, but he might still end up losing his job anyway. The first major decision Lester must make involves a manufacturing technology for producing very large scale integrated (VLSI) circuits that form the heart of a new generation of testing equipment that can be used in extremely hot or cold environments. Three alternative processes are available, and some information on these methods is presented in Table 1. With Project A, Monolithic Business Machines, Inc. would provide Humphry with all necessary equipment for manufacturing the very large integrated circuits. The initial one-time cost of this equipment would be $50 million. The actual cash inflows from this system would depend partly on sales of the new service and also on the level of mainly variable operating costs incurred by Humphry. Project B calls for Humphry to build its own production equipment but to license the Monolithic Business Machines process for making the large super-conductor chips. Initial costs with this system are not known with certainty, and it will obligate the firm to cover a substantially higher level of fixed operating costs than would be required for Project A. Project C calls for the immediate implementation, without preliminary testing, of a production process now in the final stages of development by Humphry. This alternative would avoid the expense of license fees, but production costs, quality control standards, and the reliability of the chips produced by the new method are highly uncertain. Lester noted that if the worst possible cash inflows resulted from Project C, Humphry would be insolvent and would be forced to declare bankruptcy. All of the projects cash outflows will be incurred in the first year. For lack of better information, he estimates that the actual first-year cash inflow from each project, whatever the flow turns out to be, will continue for the entire ten-year life of each project. Of course, if the large first year loss on Project C is ncurred, the company will be bankrupt.

QUESTIONS 1. Lester realises how important his first major decision is, not only to Humphry but also to his own future. Therefore, he has asked that quantifiable data upon which he will base his final decision be compiled and presented to him. Such data is in the format shown in Table 2. You must complete the blank cells for all three projects. Based on these data, which project appears to be most risky? Least risky? (2.5 Marks)

2. Calculate the internal rate of return on each project, based on expected values of the inflows and outflows. (2.5 Marks)

3. Determine the expected net present value of each project, based on expected values of inflows and outflows. Assume that a 20 percent cost-of-capital is appropriate for Humphry. (2.5 Marks)

4. With the cash flow patterns given in the case, could the net present value (NPV) and internal rate of return (IRR) result in conflicting rankings? (2.5 Marks)

5. Is it reasonable to use a 20 percent cost-of-capital for each of the projects? What methods of dealing with risk are available to Lester? Assuming that 20 percent is a reasonable cost-of-capital for an average project in the computer control industry, what are reasonable costs of capital for these projects? Explain your proposed calculations and discuss other required information, if any. (2 Marks)

6. Assume that Lester instructs you to use different risk-adjusted discount rates for each project, and that he suggests that 14 percent is reasonable for Project A, 20 percent for Project B, and 28 percent for Project C. Calculate the risk-adjusted net present values for each project. Do conflicting rankings for the risk-adjusted NPV and IRR occur? If 20 percent is used to evaluate B, what costs-of-capital for A and C would make them appear equally as good as B? (2 Marks)

7. Assume that Lesters job as president of Humphry Control & Instrument Corporation is to maximize the value of the firm and thereby maximize the stockholders wealth. Disregard his personal situation and feelings. Which approach do you think should be taken-an aggressive one or a conservative one? Now consider how Lesters personal situation might affect his decision; that is, could his personal situation cause him to make a decision that is not in the best interest of the stockholders? Which of the projects should Lester accept under each assumption? (2 Marks) 8. If the returns from Projects A, B, and C had strong negative correlation with the normal expected earnings of most firms in the economy would this affect your estimates of expected NPV? Would you still consider the most risky project you answered in Question 1 to be the riskiest project? How would it affect the overall riskiness of the firm? The overall cost-of-capital? (2 Marks)

Calculated Projected Cash Flows are shown in the Table Above

Table 1 Alternative Systems for Semiconductor Production Outflows Project A Cash Probability Outflows 1.00 $50,000,000 Probability Project B Cash Outflows $ 31,874,000 34,995,000 39,250,000 44,407,000 47,165,000 Project C Cash Probability Outflows $ 27,180,000 32,625,000 38.850,000 46,200,000 52,420,000 Inflows Probability 0.05 0.15 Project A Cash Inflows $ 6,646,000 8,670,000 9,250,000 10,800,000 12,150,000 14,000,000 Project B Cash Inflows $ 6,000,000 7,200,000 9,600,000 14,750,000 16,833,000 18,500,000 Project C Cash Inflows -$ 3,500,000 3,267,000 11,735,000 18,250,000 23,545,000 26,000,000 0.35 0.25 0.15 0.05 Table 2 Project Cash Flow Information Expected Cash Outflow Standard Deviation of Cash Outflow Expected Cash Inflow Standard Deviation of Cash Inflow Project A Project B Project C Note: The coefficient of variation is equal to the standard deviation divided by the mean: /u. Project A Project B Project C Expected Cash Standard Deviation Expected Standard Deviation of Outflow of Cash Outflow Cash Inflow Cash Inflow 50000000 1 10092800 1633841.78 40000000 4768874.06. 11877450 3842367.74 40000000 7393764.6 13816550| 7728887.17 Table 1 Alternative Systems for Semiconductor Production Outflows Project A Cash Probability Outflows 1.00 $50,000,000 Probability Project B Cash Outflows $ 31,874,000 34,995,000 39,250,000 44,407,000 47,165,000 Project C Cash Probability Outflows $ 27,180,000 32,625,000 38.850,000 46,200,000 52,420,000 Inflows Probability 0.05 0.15 Project A Cash Inflows $ 6,646,000 8,670,000 9,250,000 10,800,000 12,150,000 14,000,000 Project B Cash Inflows $ 6,000,000 7,200,000 9,600,000 14,750,000 16,833,000 18,500,000 Project C Cash Inflows -$ 3,500,000 3,267,000 11,735,000 18,250,000 23,545,000 26,000,000 0.35 0.25 0.15 0.05 Table 2 Project Cash Flow Information Expected Cash Outflow Standard Deviation of Cash Outflow Expected Cash Inflow Standard Deviation of Cash Inflow Project A Project B Project C Note: The coefficient of variation is equal to the standard deviation divided by the mean: /u. Project A Project B Project C Expected Cash Standard Deviation Expected Standard Deviation of Outflow of Cash Outflow Cash Inflow Cash Inflow 50000000 1 10092800 1633841.78 40000000 4768874.06. 11877450 3842367.74 40000000 7393764.6 13816550| 7728887.17