- The two friends own an innovative idea which they decided to make use of it by making something of essence. The idea was on creating a chip that would make work more accessible by reducing the tasks performed by about 25%. That would translate to cost savings to the company in case implemented thereby increasing the net profit. On setting up their plant and equipment, the duo estimates their installation cost to be $2500000 both on the plant, equipment, and supplies. $2500000 is, therefore, the installation cost of which it is a cost outflow to the duo. The duo project that the project is likely to be obsolete by the end of the fifth year without salvage value but after recovery of the initial cost. Instead of starting up the firm, the two estimate that they could decide to sell the chip to a manufacturer after patenting the idea. In case they sell out the chip to one of the chip makers, they would pocket $200000. The present value of $200000 could be quite less as compared to when they get the net current worth of the project in five years. Their option after selling the output would be to venture into a new ant that would help them in testing the Zircon wafers. They intended to persuade some of the manufacturers to outsource the service to them. The process is to allow the manufactures to get 100% quality check for their output instead of partial as it were before. The two had an initial investment of $2400000 and expected the project to last for five years with positive cash flows for each year. They have not estimated any salvage value for the project. The two are therefore faced with a decision of either managing their firm with the patented production method or selling the output then engaging in an outsourcing firm that would allow them to test the quality of the chips. In my opinion, I believe selling the patented then engaging in an outsourced service will be the best option since they will have their initial investment repaid within the shortest period.
- Methods that could be used to solve the decision
Payback period: The duo could use the payback period in solving out the issue. The payback period refers to the duration of time that it would take for the investment to recover the initial cost. It can alternatively be the duration that the project will take to break even. The method calculates the cost of financing by dividing with the annual cash flow. When the period is long, the investment is less attractive.
They can alternatively use NPV to determine the current value of the expected cash flows in the future that the project might generate in the future. The method may help the duo in deciding the plan with the highest profit. In calculating the Present Net Value, they need to discount all the future cash flows from the project then deduct from the initial cash invested. A project may generate high income thereby as a result of generating cash flows at a faster rate which makes it repay the initial investment within the shortest possible duration. The two should accept the project if the net present value of the project is high.
Either, they can opt for a discounted payback period method. The method calculates the number of years the business would take to break even though undertaking the initial expenditure by discounting the future cash flows thereby helping to recognize the time value of money. The method would enable the business to determine the profitability of a selected portfolio. The investment that takes less duration to repay the initial investment is the most viable project.
- If the duo uses the payback period, then it would be best to select project B since it takes a shorter duration to repay the initial investment. In the case of the net present value, project A should be recommended since it has a higher NPV. Project B is recommended when using the IRR and MIRR and profitability index methods.
- NPV approach should be preferred over the others since it accounts for all the cash flows that the business gets as compared to the other techniques like payback and the discounted payback methods which ignore the cash flow beyond the payback period. The net present value should also prefer above different ways since it factors the business risks by using the discount rates which captures the business risk, operating risk and financial risk. The technique is also considered as a good measure of profitability. In case the business wishes to select from a single project among many, then NPV will be better as compared to IRR and the payback period methods. If the company decides to use the IRR for the mutually exclusive projects, then it may end up having portfolios with short term return at the expense of the long term which creates value for the shareholders through generating high NPV.
- a. I would recommend since it has a higher return based on the net present worth. The projected cash flows increases as the year’s increase which is a good indication of a going concern. I would also select the portfolio since selection based on the net present value factors the risk thereby making it possible to know what the business should expect.
- Limitations of the approach
It is not easy to determine the rate of return at which the cash flows need to be discounted. The method may also apply optimistic projections which may end up failing. The short term projections may not boost the earnings per share and the business return on equity which may not work in favor of the shareholders.