Silicon Arts Inc. (SAI) is a manufacturer of circuits that are used in a number of different electronic equipment (University of Phoenix, Simulation, 2006). In their first years, they saw first a huge soar in the industry, but that was swiftly followed by a 40% downfall in subsequent years. SAI dealt with this by tightly controlling their expenses. Current markets trends indicate that the industry may be on the rise. Consequently, and with the help of their new CFO, the company now wants to develop some new capital investment projects. SAI’s current goals are to increase their market share and to keep pace with new technology (University of Phoenix Simulation, 2006).
The first task on the agenda was to examine the probable future scenarios that could potentially accept the cash flows for SAI and their two potential projects, Dig-Image and W-Comm. Included in SAI’s plans are the need to make $54 million in their first year by selling at least 400,000 units produced in Sunnyvale; they 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,” (Ross, Westerfield & Jaffe, 2006, p. 183).
They are expecting that the growth will be 20% in the first three years, and then they are predicting a sales decrease of 10% to a total of 0% in years 4 and 5 (University of Phoenix Simulation, 2006). SAI is expecting some challenges with this new venture; not only is there intense competition, they are expecting priced to drop year to year, and they are also expecting this technology to be replaced soon, perhaps even before the lifespan on their project has run out.
Although increasing the volume of units will increase the NVP and IRR, this will not be a realistic or sustainable solution. Rather, applying a modest yearly increase and encouraging a high percentage of sales to be spent on sales will be the most sensible option. Throughout this process, the CFO made extensive use of the IRR and NVP analysis to guide her choices. “Though NVP is the best capital budgeting approach conceptually, it has been criticized in practice for providing managers with a false sense of security,” (Ross, Westerfield & Jaffe, 2004, p. 227). Overall, the strategy yielded the following NVP and IRR for Dig-image and W-Comm, detailed in Table 1.
Table 1: Part 1 NVP and IRR Analysis for Dig-image and W-Comm
NVP (in 000s) IRR (in %)
Dig-image 12,007 28.1
W-Comm 14,071 31.5
The second part of the task involved analyzing the capital expenditure decisions for some required machinery at their facility. There were essentially two options: (a) to use an existing vendor, an industrial constructor, (Hathaway Industrial Systems) as well as their equipment supplier, C6 systems, and (b) multinational contractors, J & T. It is now the CFO’s job to negotiate the best deal possible for the company; the consensus was that both vendors were on the uneconomical side.
The decision was to go with J ; T, as they yielded the highest NVP and IRR, at 12,553 and 29.6%, respectively, versus Hathaway and 6C, who yielded an NVP and IRR of 12,007 and 28.10%. As these are very close, it could have gone either way.
The next step was to decide on the phase payment. Arrangements were made to have a split phase payment, at 50% year one, and 25% for years two and three. It was decided that there should definitely be a salvage value at the end of the useful life of the equipment in 5 years. 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. As it is now, if one calculates their net cash flow, which is Sales Revenue – Operating
The final part of this step relates to either using the IC 1032 technology that was developed in-house, or to buy out DigIC, who owns a state-of-the-art IC for Wireless communications patent. The decision was originally to go with the in house technology; it was decided that the DigIC technology was not yet tested enough. However, the owner of DigIC changed the eal and said that SAI could use payment terms of 60% upfront and the remaining 40% as a yearly retainer fee.
This positively affected the NVP and IRR, where for DigIC, it was 14623 for the NVP and 32.40% for the IRR, versus 14071 for the NVP and 31.50% for the IRR for the in-house R;D option. Upon first glance, the R;D option looks like the best one; it supports in-house expertise, and they are both very close. It was also decided that there would in fact be a terminal value associated with the purchase, which was determined to be 5% of the Capex.
Overall, the strategy yielded the following NVPs and IRRS for Dig-image and W-Comm
Table 2: Part 2 NVP and IRR Analysis for Dig-image and W-Comm
NVP (in 000s) IRR (in %)
Dig-image 12,553 29.6
W-Comm 14,702 32.5
The third and final part of the analysis involved adjusting for risks, equalizing time frames, and calculating profitability indices. There are different amounts of risk for each project. This has to be factored in when calculating the NVP. Adjustments needed to be made to the discounting rate; it was decided that the rates should be 2% 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 looking at approximately 2% greater returns than were actually going to be realized.
Further, 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 as they are now based over two different time spans, and it is important to compare the two on as like terms as possible. In this way, one will be able 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 details the final decisions that were made on the risk premium, equalizing timelines and calculating the Profitability index.
Table 3: Part 3 Final Analysis for Dig-image and W-Comm
Risk Premium Equalizing Timelines (in 000s) Profitability Index NVP (in 000s) IRR (in %)
Dig-image 2 3,433 1.26 11,201 29.60
W-Comm 2 3,123 1.42 11,260 31.70
Based on these results, it was decided that the best choice would be W-Comm.
It was a difficult choice to decide between the two capital projects. Both were very close in value and what seemed to be the best choice initially was not always found to be so, after careful scrutiny. The first step started out by looking at probable future scenarios, and helped to determine the initial cash flow, costs and sales objectives. The second step involved determining the details of the Capex. There it was decided that Gus Longman would win the contract, for technology, also with J & T for the vendor. It was also determined that there should be some sort of salvage value at the end.
The final phase included determining the PI, equalizing the timelines and adjusting for risk in the market, to make both of the projects truly representative of each other. Overall, the choice was made to go with W-Comm as a project, but it really was close either way. It could have been different if the CFO had decided to be really aggressive with her assumptions and calculations. Overall, she made a good choice; it is always better to be conservative when dealing with millions of dollars.