Risk Analysis On Investment Decision
The capital budgeting simulation presented a company by the name of Silicon Arts Inc. Silicon Arts Inc., is a four-year-old company that manufacturers digital imaging integrated circuits wants to increase their profit share and keep pace with technology. Silicon Arts Inc. is looking to expand by pursuing two objectives: increase market share and keep pace with technology. This paper will discuss the valuation techniques to external investment strategies and internal investment strategies to make a final decision on the project. The decision will be made by analyzing the cash flow projections, opportunity costs, NPV, IRR, and the Profitability Index.
Silicon Arts Inc. presented two capital investment proposals to their Financial Analyst to make a final decision. Dig-image proposed the details of setting up a plant in Sunnylane, CA, and the plant would produce the existing range of Silicon Arts Inc. circuits. The project life is estimated to be five years and will make a 30% contribution to Silicon Arts Inc. annual revenue. Silicon Arts Inc. is projected to generate revenues $54 million through the sale of 400,000 chips. The capital outlay plant is around $40 million, and the plant capacity is 10,000 units per day; the cost of capital of 17%.
W-Comm proposed the production of IC 1032 on a commercial scale. The project life is estimated to be seven years, and Silicon Arts Inc will capture 3-4% of the 12.5 million data enabled mobile handsets by the fourth year. Real estate in Santa Clara is the area projected to be used for the first three years. The capital outlay plant is around $18 million which will include the machinery cost and the research development cost. The plant will produce 1000 units per day. The capital outlay plant is around $16 million, and the plant capacity is 3000 units per day; the cost of capital of 18%.
Valuation Techniques involved in the External Investment Strategies
A merger involves the “The acquiring firm retains its name and its identity, and it acquires all of the assets and liabilities of the acquired firm.” (Ross, Westerfield, & Jaffe, 2005, p. 797). It also requires a vote from the stockholders of each firm involved. With the merger and consolidations, it’s a combination of assets and liabilities the firms. “Capital budgeting is the decision-making process for accepting or rejecting projects.” (Ross, Westerfield, & Jaffe, 2005, p. 144). The decision-making process consists of various external and internal investment strategies, including the NPV of an acquisition, source of synergy from acquisitions, reducing the cost of capital, and the cost of equity capital.
Silicon Arts Inc. will need to analyze the revenue enhancement which is generating revenue through market gains, strategic benefits or monopoly power. Cost reduction will be beneficial in determining the economic scale of the cost of production, or the integration of the companies. Silicon Arts Inc. can not afford to ignore the market value, estimation on the incremental cash flows, using the correct discount rate, and forgetting the transactions costs. “The gains to creditors are at the expense of the shareholders if the total value of the firm does not change.” (Ross, Westerfield, & Jaffe, 2005, p. 809). “Firms typically use NPV analysis when making acquisitions. The analysis is relatively straightforward when the consideration is cash.” (Ross, Westerfield, & Jaffe, 2005, p. 813). Silicon Arts Inc. could consider a merger with Dig-image that is currently in the wireless market. This company has already developed and patented the IC 1032 for Wireless Communications. Silicon Arts Inc. decided to stick with their own IC 1032 technology that was developed by the research and development division. The technology that the other company has is very expensive and has yet to be tested. It would not be economical for Silicon Arts Inc to take on this new product because they would end up spending additional resources testing the new technology for optimum.
Valuation Techniques involved in the Internal Investment Strategies
The valuation techniques involved in the internal investment strategies are the cost of equity capital which is the rate of return needed by a company’s common stockholders. The expected return needs to be greater than the risk. Several factors could affect the company’s beta such as production, technology or the market. “While there is no formula for selecting the right beta, there is a very simple guideline. If one believes that the operations of the firm are similar to the operations of the rest of the industry, one should use the industry beta simply to reduce estimation error. However, if an executive believes that the operations of the firm are fundamentally different from those in the rest of the industry, the firm’s beta should be used.” (Ross, Westerfield, & Jaffe, 2005, p. 326). With a discount on the cash flow the wireless communications project had a NPV of 14,026 and the digital imaging had a NPV of $5,448 showing an internal rate of return of 32.00 for wireless communication and 23.40 for digital imaging. After the analysis of whether to use an outside vendor or stay in-house the NPV increased to $14,429 for wireless and $5,890 for digital with a small change in the IRR. Silicon Arts Inc. assumed a risk rate of 3% and a risk-premium of 3% giving an estimate cost of equity capital of 1.38%. This information helped to analyze the risk associated with the investment decisions that Silicon Arts Inc. has to make.
Risks Associated with Investment Decisions
Silicon Arts Inc. has to go beyond the basic risk approach and use the sensitivity analysis approach to analyze the impact of risk on capital budgets. The simulation allowed a simple sensitivity analysis of NPV changes as a result of changes in cost of capital, cash flow and sales projections. This tool helps to identify the probability that the project value will become negative. “Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions” (Ross, Westerfield, & Jaffe, 2005, p. 10). Based on the scenario it seems that both Dig-Image proposal and W-Comm proposal have something to offer. However, risk factor is different in both proposals. One similarity is that Silicon Arts Inc. will be faced with tremendous amount of competition. This might set them back in their profits. Looking at the analysis of both proposals if Dig-Image is projecting a 25% increase in Year 2 and 3 and a 15% increase in year 4 and 5 then there might be a chance of decrease of price in both intervals by 5% and the projected NPV of $13,827 and projected IRR of 30.50. On the other hand, if W-Comm increased Year 2 and 3 to 15% and year 4 and 5 by 10% and decrease price by 5% for each interval would discover that the projected NPV is $13,991 and IRR is 31.30.
The cash flow for the wireless communications projects show an optimistic outcome of net cash flow for seven years with little capital investment versus cash flow for five years with larger capital investment. Working capital shows small changes with minor cash inflows for wireless compared to large cash inflows. Therefore, the analysis shows that the best project would be to go with the new market of wireless communication using the existing building with little capital outlay. Using the external and internal investment strategies when working through the scenario of Silicon Arts Inc. can help to analyze the risks associated with the investment decisions of expanding in existing market or entering into the new market of wireless communication.
Ross, Stephen A., Westerfield, Randolph W., & Jaffe, Jeffrey. (2005 ). Corporate Finance (7th ed.). , The McGraw-Hill Companies.
University of Phoenix. (2008). Week Three Scenario: Silicon Arts, Inc. Retrieved
May 10, 2008, from University of Phoenix, Week Three, rEsource, MBA540- Maximizing Shareholder Wealth Course Web site.