FIN 390 Assignment – Fall 2020
Capital Budgeting Mini Case
Instructions: The assignment is based on the mini case below. The instructions relating to the
assignment are at the end of the case.
Rosa Lee and Scott Bradshaw are facing an important decision. After having discussed different
financial scenarios into the wee hours of the morning, the two computer engineers felt it was
time to finalize their cash flow projections and move to the next stage – decide which of two
possible projects they should undertake.
Both had a bachelor degree in engineering and had put in several years as maintenance engineers
in a large chip manufacturing company. About six months ago, they were able to exercise their
first stock options. That was when they decided to quit their safe, steady job and pursue their
dreams of starting a venture of their own. In their spare time, almost as a hobby, they had been
collaborating on some research into a new chip that could speed up certain specialized tasks by
as much as 25%. At this point, the design of the chip was complete. While further
experimentation might improve the performance of their design, any delay in entering the market
now may prove to be costly, as one of the established players might introduce a similar product
of their own. The duo knew that now was the time to act if at all.
They estimated that they would need to invest $5,000,000 on plant, equipment and working
capital. As for future cash flows, they felt that the right strategy at least for the first year would
be to sell their product at dirt-cheap prices in order to induce customer acceptance. Then, once
the product had established a name for itself, the price could be raised. By the end of the fifth
year, their product in its current form was likely to be obsolete. However, the innovative
approach that they had devised and patented could be sold to a larger chip manufacturer for a
decent sum. Accordingly, the two budding entrepreneurs estimated the cash flows for this project
(call it Project A) as follows:
Year
Project A
Expected Cash flows ($)
0
($5,000,000)
1
$190,000
2
$885,000
3
$2,140,000
4
$3,110,000
5
$3,110,000
An alternative to pursuing this project would be to immediately sell the patent for their
innovative chip design to one of the established chip makers. They estimated that they would
receive around $300,000 for this. It would probably not be reasonable to expect much more as
neither their product nor their innovative approach had a track record.
They could then invest in some plant and equipment that would test silicon wafers for zircon
content before the wafers were used to make chips. Too much zircon would affect the long-term
performance of the chips. The task of checking the level of zircon was currently being performed
by chip makers themselves. However, many of them, especially the smaller ones, did not have
the capacity to permit 100% checking. Most tested only a sample of the wafers they received.
Rosa and Scott were confident that they could persuade at least some of the chip makers to
outsource this function to them. By exclusively specializing in this task, their little company
would be able to slash costs by more than half, and thus allow the chip manufacturers to go in for
100% quality check for roughly the same cost as what they were incurring for a partial quality
check today. The life of this project too (call it project B) is expected to be only about five years.
The initial investment for this project is estimated at $4,900,000. After taking into account the
sale of their patent, the net investment would be $4,600,000. As for the future, Rosa and Scott
were reasonably sure that there would be sizable profits in the first couple of years. But
thereafter, the zircon content problem would slowly start to disappear with advancing technology
in the wafer industry. Keeping all this in mind, they estimate the cash flows for this project as
