Q1

Ali and Fatima are facing an impertant decision. After having discussed different financial scenarios, the two computer engineers felt it was cime to flnalize their cash flow projections and mave to t next stage decide which of two possihle projects they shuuld 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 manths ago, they were able to exercise their first stock options. That was when they decided to quit their sate, steacly job and pursue their dreams of starting a veniture of their own, In their spare time, almost as a hobby, they had been coliabarating on same research Into a new chlp 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 suppiles. As for future cash flows, they felt that the right strategy at least for the first year would be to sell their praduct 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 ta 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 flow

0 (1000000)

1 year 40000

2 year 200000

3 year 500000

4 year 1000000

5 year 1300000

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. Ihey estimated that they would receive around $200,000 for this. It would probably not be reasonable to expect much mare as neither their product nor their Innovative approach hed a track record.

They could then invest in some plant and equipment that would test sillcon wafers for atrcon 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 af them, especially the smaller ones, did not have the capacity to permit 100% checking, Most tested only a sample of the waters they received. Ali and Fatema were confident that they could persuade at least sorte 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 partlal quallty check today. The life of this project teo (call it project B) is expected to be only about five years.

The initial investment for this project estimated at $ 1,100,0co. After taking into account the sale of their patent, the net Investment wauld be sgo0,000. As for the future, Ali and Fatema were pretty sure that there would be sizable profits in the first couple of years. But thereafter, the zircon content problem would slawly stert to disappear with acvancing technology in the water industry. Keeping all this in mind, they estimate the cash flows for this project as follows:

Project B

Year expected Cash flow

0 (900000)

1 year 750000

2 year 600000

3 year 500000

4 year 400000

5 year 200000

All and fatima now need to make their decision. For purposes of analysis, they plan to use a required rate oft return of 10% for beth projects. Ideally, they would prefer that the project they choose have a payback peried of less than 3.5 years and a discounted payback period of less than 4 years.

Evaluate both the projects based on Capital Budgeting techniques and Mention the most feasible project to invest as per the above mentioned techniques.