Capital Budgeting Memorandum Case Study Examples
Dear Maria and Bob,
Further to our previous communications and according to our service contract, please find below requested analysis of issues relating to 2 considered projects, i.e. Project A and Project B, to be implemented to introduce your newly designed and patented chip.
1. Summary of issues relating to Project A and Project B implementation
The key facts of Project A and Project B implementation are as follows:
Maria Gonzalez and Bob Saunders conducted a research and designed a new chip that could speed up certain specialized tasks by as much as 25%.
There are two feasible options to launch the newly designed chip, i.e. Project A and Project B. Both options have an expected life cycle of 5 years and require initial investment in the amount of USD 2,000,000.
Project A envisages acquisition of a plant, equipment and supplies for the total amount of the initial investment. A market niche of the newly designed chip will be gained by introducing a low price at the early stage of the project implementation with its further increase during the 5-year life cycle. At the end of the product life cycle, the innovative approach that Maria and Bob had devised and patented could be sold to a larger chip manufacturer for a decent sum.
Project B envisages a sale of the entrepreneurs’ innovative chip design to one of the established chip makers in the first place for the preliminary amount of USD 200,000. Thus, the net initial investment of USD 1,800,000 would be spent on acquisition of a plant and equipment that would test silicon wafers for zircon content before the wafers were used to make chips.
All cash flow projections for Project A and Project B are made in accordance with the entrepreneurs’ estimates. Such estimates may be rather reliable, as both Maria and Bob have a bachelor’s degree in engineering and several years of working experience as maintenance engineers in a large chip manufacturing company.
Thus, the entrepreneurs are currently facing a problem relating to selection of the most suitable option to launch their newly designed chip taking into account the financials of Project A and Project B, as well as their credibility.
2. Different approaches that could be used in the decision-making process
In order to evaluate attractiveness of Project A and Project B, the following approaches may be used: payback period approach, discounted payback period approach, NPV approach, IRR approach, profitability index (PI) approach, MIRR approach. Furthermore, a combination of any of the above-mentioned approaches may also be used in the decision-making process.
3. Ranking of Project A and Project B
Please find below performed ranking of the projects in terms of different criteria.
Ranking of Project A and Project B in terms of their financials
4. Selection of the best suitable approach for the decision-making process
Please note that the NPV approach should not be solely used for the decision-making.
This is due to the fact that the NPV only represents a present value of incoming and outgoing cash flows relating to a particular project. Therefore, the NPV does not indicate profitability of a project in any way.
Moreover, the NPV approach used to compare projects with different amounts of initial investment provides irrelevant results.
Taking into account the current situation, it is advisable for Maria and Bob to use the discounted payback period approach and the MIRR approach to compare the attractiveness of Project A and Project B.
Both proposed approaches have advantages over the other approaches. Thus, the discounted payback period shows when it is expected that Maria and Bob would return their initial investment in the project regardless of initial investment and taking into account loss of value of the investment over the project life period. To the contrary, the payback period approach does not imply that the invested funds would lose their value in the course of time.
Furthermore, the PI approach comparing to the IRR approach and the MIRR approach does not imply that any positive cash flows during the project life cycle could be reinvested. In this regard, it is recommendable to use the MIRR approach that assumes that the positive cash flows would be reinvested. Unlike the IRR approach that suggests that the possible reinvestment of funds would be at the same rate of return as the project itself, the MIRR approach eliminates this unrealistic suggestion.
5. Recommendations regarding project selection
It is advisable to invest in Project B taking into account the following:
Project B has a higher MIRR meaning that the Project B is more lucrative.
Moreover, the Project B requires less net initial investment than Project A.
Project B has a shorter discounted period. Thus, Maria and Bob would return their invested funds faster. In addition, it will be safer to receive the investment back as soon as possible if, for instance, some projections are unrealistic.
6. Limitations of the performed analysis
The following limitations of the approach were considered in the decision-making:
There are necessary funds for investment and, therefore, no loan will be taken.
The requested 15% rate of return is in line with market conditions.
The cash flow estimates on average respond to the current market situation.
Neither an inflation rate nor possible licensing fees, taxes and acquisition expenses were taken into consideration while comparing Project A and Project B.
It was assumed that there is no other option to invest available USD 2,000,000 in a project with a higher rate of return and/or MIRR.
Within the framework of Project A, Maria and Bob could attract clients by low prices and could sell their innovative approach at the end of the 5-year life cycle.
For Project B, the estimates regarding slashing the company’s costs and slow solution of the zircon content problem with advanced technology are realistic.
At the end of the 5-year period, the book values of the plant, equipment and supplies within the framework of Project A and Project B are equal.
It is advisable to further analyze the following issues:
expected inflation in the nearest 5-year period;
possible licensing fees, taxes and other expenses relating to acquisition of the plant, equipment and supplies;
absence of other options to invest available funds at a higher rate of return;
book values of the plant, equipment and supplies at the end of the 5-year period.
Please remember that this paper is open-access and other students can use it too.
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