Capital Budgeting: The Ultimate Guide

In this case, the two prospective entrepreneurs are Samantha Groves and Harry Finch. The two resigned from their employment as maintenance engineers in a large chip manufacturing six months ago to pursue their dream of their own in chip manufacturing sector. Already, the two have invented a new chip design capable of speeding up specific specialized tasks by as much as 25 %, and they are planning to enter the market as soon as possible before the design is invented by another chip manufacturer. At this point, the two are faced with a serious investment decision as they are considering two investment options in regards to their new chip design. First, (Project A) they are considering manufacturing new chips themselves a venture they estimate will require $ 1,250,000 as the initial capital outlay with increasing projected cashflow trend for the five years of the project lifetime. The other investment (Project B) they are considering is to sell their chip design to another already established manufacturer at the cost of $ 100,000 and venture into chip wafers testing. This investment is requiring an initial investment of $ 1,050,000 in addition to the what they will receive after selling their chip design. Further, the two have analysed various capital budgeting techniques to help them in making the right investment decision. Therefore, the decision facing the two is as to which investment option to choose between project A and Project B. 

Question 2 

The approaches that can be used to solve this decision problem is using capital budgeting techniques. The capital budgeting metrics to be used in this case are Payback Period, Discounted Payback Period, Net Present Value, Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR) and Profitability Index. To make the right decision in this case, the techniques acceptance criteria will be used. Based on the payback period and discounted payback period (in years), they should accept the project if the computed payback is less than the five years project duration. Based on Payback period, they should accept project B because it has less payback time in years than project A. 

Based on the Net Present Value (NPV), they should accept the venture if the computed NPV is positive. However, in case since both projects have positive NPV, project A shall be acceptable as it has a higher NPV value than project B. Based on the Internal Rate of Return (IRR) and Modified Rate of Return (MIRR), they should accept the project whose IRR and MIRR is higher than the set rate of return of 15%. Therefore, the two projects are acceptable, but they should choose project B because it has a higher IRR and MIRR than project A. Based on the Profitability Index (PI), they should accept the project whose PI is more than 1. However, in this case, they should accept project B as it has a higher PI than project A. 

Question 3 (i) 

Ranking the Projects 

Question 3 (ii) 

In this case, Samantha is considering Net Present Value (NPV) as the ultimate approach to consider in making the final decision because when computed NPV is positive, and it is conflicting with all the other capital budgeting techniques, the NPV is considered to prevail above all as it gives the absolute profitability value of the investment. However, this only applies to projects with equal cashflows and same timeline. In this case, the computed value of NPV cannot, thus, be considered to prevail against the others as both projects A and project B have the same timeline but their cashflow timing is different. Therefore, as Harry proposes, they need to evaluate the suitability of the project based on more than one capital budgeting metric. This means that project B is more suitable to undertake compared to project A as shown by the ranked capital budgeting metrics of Payback Period, Discounted Payback Period, Internal Rate of Return, Modified Internal Rate of Return and the Profitability Index. 

Question 4 (i) 

Based on the analysis, the recommendable project to the two prospective entrepreneurs is project B which involves selling their chip design and investing in chip wafer testing for smaller chip manufactures for an estimated period of 5 years. This is because the project is ranked number one by all the analysis metrics of Payback Period, Discounted Payback Period, Internal Rate of Return, Modified Internal Rate of Return and the Profitability Index excluding the Net Present Value only which cannot be considered in this case due to uneven cashflows timing. This indicates that by undertaking project B, the two entrepreneurs can attain their set objectives very easily. 

Question 4 (ii) 

The limitation of the five capital budgeting approaches used in making the project B acceptance decision is as follows. For Payback Period, the approach ignores the time value of money, and also it doesn’t measure project profitability. For Discounted Rate of Return, the approach is relatively difficult to compute and apply in decision making. For the Internal Rate of Return and Modified Internal Rate of Return the approaches don’t measure the actual project rate of return, and also, they are cumbersome regarding computation and analysis. Finally, for the Profitability Index, the approach conflicts with other decision metrics, and it is also complex to compute. My recommendation, in this case, is that investment decisions to be based on more realistic data that permits for analysis of decisions making techniques in a realistic manner, thus, permitting for better decision making on the investment matters.