Running head: CAPITAL BUDGETING

Risk Analysis on Investment Decision Risk Analysis on Investment Decision
Silicon Arts, Incorporated (SAI) is a manufacturer of circuits that are used in the manufacture of electronic equipment items. During their initial years in operation, there was an increase in the industry followed by a 40% decline. In order to remain competitive and stay profitable, SAI controlled expenses. Current trends indicate the industry may be on the rise again. SAI wants to develop some new capital investment projects that are in line with their goals: increase their market share, and keep pace with new technology (University of Phoenix, 2007).
Future Scenarios
The first task in the simulation was to examine probable future scenarios that could potentially affect SAI cash flow with two projects, Dig-image and W-Comm. Part of SAI’s plans is their desire to earn $54 million in their first year by selling 400,000 units, however they first need to determine their working capital. “Working capital rises over the early years of the project as expansion occurs. However, all working capital is assumed to be recovered at the end, a common assumption in capital budgeting” (Ross, Westerfield, & Jaffey, 2005, p. 183). SAI is expecting growth will be 20% in the first three years and then decrease 10% annually in years 4 and 5. SAI is expecting increasing competition, decreasing prices, and a short lifespan of the technology that could be obsolete before the lifespan of the project itself.
Although increasing the volume of units will increase the NVP and IRR, this is not a feasible solution, nor is it a sustainable one. Instead SAI should consider a modest, yearly increase and encourage a high percentage of sales as the most viable option. Throughout this process, the CFO made extensive use of IRR and NVP analysis to guide their decision making. Since the NPV approach uses cash flows instead of profits, it “uses all the cash flows, and discounts the cash flows properly, it is hard to find any theoretical fault with it” (Ross et al, 2005, p. 213). It also can provide a false sense of security. Table 1 depicts the NPV and IRR results from the simulation using the strategy selected for Dig-image and W-Comm.
Table 1. NPV and IRR Analysis (Task 1) NVP (in 000s) IRR (in %)
Dig-image 15,413 31.20
W-Comm 16,209 32.40
Analyze Capital Expenditure Decisions
The second part of the scenario involved analyzing the capital expenditure decisions for machinery at the SAI facility. There were two options: (a) to use an existing vendor, an industrial constructor, Hathaway Industrial Systems and their equipment supplier, C6 Systems, and (b) multinational contractors, J & T. It was the job of the CFO to negotiate the best deal possible for the company. The decision was to go with J & T, as they yielded the highest NPV and IRR, at 15,959 and 33.2%, respectively, versus Hathaway and 6C, who yielded an NVP and IRR of 13,575 and 29.8%.
The next step was to decide on a phase payment system. It makes more sense to break up the capital purchase into successive years; it would cripple their cash flow to have it all come out in the first year. Therefore, the decision was made to have a split phase payment with 50% due the first year, and 25% for years two and three. It was also decided that there should be some form of salvage value at the end of the useful life of the equipment (in year 5).
The final part of this portion of the scenario was to decide if SAI should use the technology developed in-house, or to outsource operations to Gus Longman. The decision was originally to go with the in house technology; it was decided that utilizing Gus Longman was more cost efficient with payment terms of 60% upfront and the remaining 40% as a yearly retainer fee. This positively affected the NVP and IRR, where for Longman it was 16,760 (NPV) and 33.30% (IRR), versus the in-house R&D numbers of 16,209 (NVP) and 32.4% (IRR). At first glance the R&D option would appear to be the best one since it uses in-house expertise, however it was also decided that there would be a terminal value associated with the purchase, which was determined to be 5% of the Capex. Table 2 shows the NVPs and IRRs for Dig-image and W-Comm based on this portion of the scenario:
Table 2. NPV and IRR Analysis (Task 2) NVP (in 000s) IRR (in %)
Dig-image 15725 32.9
W-Comm 16,893 33.4
Adjusting for Risks
The third and final part of the scenario involved adjusting for risks, equalizing time frames, and calculating the profitability indices. There are risks for each project that must be factored in when calculating the NVP. Adjustments needed to be made to the discounting rate and it was decided that the rates should be 0% for Dig-image and 2% for W-Comm. This was decided because SAI’s market share in the industry has a risk of being competed against with like products. While the market is increasing, it is risky, and research showed that investors were expecting higher returns with the W-Comm approach, but hoped for higher ones with Dig-image.
Furthermore, it was decided that it would be the best thing to equalize the timelines, and to use the profitability index. It is important to equalize the timelines since the projects have two different time spans, and it is important to compare them as equally as possible. This allows decision makers to see the equivalent annual cash flows. The Profitability Index was used to find out which project has the highest value per dollar of investment. Table 3 shows the final decisions made on the risk premium, equalizing timelines and calculating the Profitability index.
Table 3. Final Analysis (Task 3) Dig-image W-Comm
Risk Premium 0 2
Equalizing Timelines 5,028 3,822
Profitability Index 1.4 1.52
NVP (in 000s) 15,725 13,778
IRR (in %) 32.9 33.4
Even though W-Comm has a higher PI and IRR, it was decided that the best choice would be Dig-image with the better NPV.
Conclusion
The scenario was a thought-provoking exercise in financial operations. The first step looked at probable future scenarios and helped determine the initial cash flow, costs and sales objectives. The second step involved determining the details of the Capex. It was decided Gus Longman would be the contractor for technology and J & T as the vendor. It was also decided there should be some salvage value at the end of the project. The final step included adjusting for risk, equalizing the timelines, and determining the PI. In the end, the decision was made to go with the Dig-image project. References
Ross, S. A., Westerfield, R. W., & Jaffe, J. (2005). Corporate Finance (7th ed.). New York: McGraw-Hill/Irwin.
University of Phoenix. (2007). Capital Budgeting Scenario. In MBA/540 Finance for Managerial Decision Making. Retrieved July 3, 2007, from University of Phoenix eResource Web Site: https://mycampus.phoenix.edu/secure/resource/vendors/tata/sims/finance/budgeting/finance_budgeting_frame.html