Samples Business Capital Budgeting Mini-Case

Capital Budgeting Mini-Case

827 words 3 page(s)

Question 1: Case Facts and Problem Summation

Groves and Finch have several years of experience in a large chip manufacturing company as maintenance engineers. Both individuals were able to exercise their first stock options about 6 months ago, choosing to start their own venture, where they are attempting to determine what projects should be undertaken. These projects are part of a research collaboration involving a new chip, which could increase the speed of specialized tasks by 25%. While the chip design is complete, it is recognized by Groves and Finch that further experimentation may yield better performance. At the same time, Groves and Finch recognize that market entry delay may be costly because a more established company may introduce a similar product. Project A and Project B are being considered.

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Project A: Groves and Finch expect to purchase PPE for about $1,250,000. For the first year’s cash flows, it is planned to sell the chip for very low rates to gain customer acceptance. Following product acceptance and establishment, the price will be raised. By the end of the fifth year, the product will most likely be obsolete. However, they could yield a salvage value because the innovation used was patented and could be sold to a larger chip manufacturer. The proposed cash flows would increase from $75,000 (Year 1) to $775,000 (Year 5) with Years 1 to 4 increasing and an initial investment of $1,250,000 for PPE.

Project B: Alternatively, Groves and Finch could sell the patent for the innovation for about $100,000. It was understood that without establishment of the innovation or product, a higher rate would not be likely. Through this sale, Groves and Finch would be able to invest in PPE, allowing them to test silicon wafers for zircon content because excessive zircon had an impact on long-term chip performance. Chip makers were performing zircon levels, but many only tested a sample. With the investment in PPE, Groves and Finch alternatively proposed that chip makers could outsource this testing to them, allowing them to specialize in this test. Costs would be reduced by over half and the chip manufacturers would be able to have 100% of the silicon wafers tested prior to use in chips for about the same cost as they were paying for sampling. The lifespan of this project is expected to be about 5 years. The initial investment would be $1,050,000 (following the sale of the patent). Cash flows would range from $650,000 (Year 1) to $62,500 (Year 5), with each year decreasing slightly.

The problem being addressed is to determine which project – A or B – would be most beneficial for their venture. The required rate of return is 15%. The desired payback period is, at most, 4 years. The discounted payback period is, at most, 5 years. Based on the current analysis, the payback period and discounted payback period meet the minimum requirements. However, Groves and Finch are concerned about cash flow estimate reliability.

Question 2: Problem Solving Approaches

The most effective solution would be to conduct a sensitivity analysis for the cash flows for both projects. For these analyses, the expected cash flows determined by Groves and Finch could be used as the base values. The sensitivity could be 10% less than the base value, or other percentages. This would give different cash flows for both projects that would give Groves and Finch different results for the analyses of rate of return, payback period, and discounted payback period. The most effective decision could be made based on these differences.

Question 3a: Ranking of Projects

For the ranking, the closest is being marked to the requirements or the most effective if both meet the requirements (only in payback period and discounted payback period).

Payback period Project B
Discounted payback period Project B
NPV Project A
IRR Project B
Profitability index Project B
MIRR Project B


Question 3b: Best Approach

The best approaches are NPV, internal rate of return, and payback period. This would provide different metrics. Many companies state that at least two of three metrics must meet minimum requirements. However, since the venture is so new, it may be more beneficial to ensure that all these metric requirements are met. This should also hold true for a sensitivity analysis, where the accepted project is the one where all three metrics are accepted in the worst-case scenario.

Question 4a: Project Recommendation

Based on the existing analysis, Project B is recommended because it has the highest outcomes. Moreover, since the venture would become a specialist, they will have a new niche within the market, which could be expanded upon for future uses, enabling the company to progress further. If the venture were to only focus on chips, they would have a more significant challenge because they are not established within the market.

Question 4b: Limitations of Decision-Making Approach

The major limitation is that the expected values were used in the analysis. There is a major concern by Groves and Finch that these values may not be accurate. Therefore, it is recommended that a sensitivity analysis is conducted to determine the most effective project.