Capital Budget Simulation

1 Risk Analysis Running Head: Risk Analysis

Risk Analysis of Investment Decision Shelli Young Maximizing Shareholder Wealth University of Phoenix March 16, 2009

2 Risk Analysis Introduction SAI is a digital imaging integrated circuits manufacturer established approximately four years ago. The products manufactured by SAI are primarily used in digital cameras, DVD players, computers, and in medical and scientific instruments. Capital budgeting decisions analyze the net present value (NPV), the internal rate of return (IRR) and cash flows of the project. This paper will discuss the valuation techniques of an internal and external investment strategy, as well as the risks associated with investment decisions. In the last few years, Silicon Arts Incorporated’s revenues have decreased by nearly 40% due to industry downslide leading SAI to freeze capital expenses and reduce capital costs. Kathy Lane, Chief Financial Officer of Silicon Arts Inc., requested the post financial analyst to analyze two capital investment proposals set-up by Hal Eichner, chairman if SAI, and determine the best proposal to increase market share and help SAI remain competitive. SAI is faced with deciding to expand the existing digital imaging market share or enter into the wireless communication market by determining net present value and internal rate of return. SAI’s first option, Dig- image is an internal investment strategy designed to expand their existing digital imaging market share. The second option, W-Comm is an external investment strategy proposal to enter the wireless communications market. The capital budgeting process including: net present value (NPV), internal rate of return (IRR), and profitability index (PI) will be applied to each proposal, revealing the best investment decision for SAI. The Dig-image proposal provides evidence that the digital imaging market will grow nearly 20% in year 1, then an additional 7% each year thereafter. SAI already holds 18% of the current market and has the potential to expand this market should it open up manufacturing in Sunnyvale adding and projected 30% contribution to revenue over five years. The W-Comm

3 Risk Analysis proposal states approximately 12.5 million data enabled mobile handsets will be sold by year 3, and of the 12.5 million, SAI could potentially gain approximately 3% market share. For the first three years, production of the commercial units required to enter into this market can be manufactured using excess real estate. Internal Investment Strategy Techniques SAI’s internal investment strategy Dig-image is five-year project requiring a capital outlay of approximately $40 million dollars at a cost of 17%. The land for the proposed plant was purchased in 2000 for $10 million; this is considered a sunk cost. Barriers included in this proposal are intense competition and price wars. Initially, a decision was made to go with an existing vendor of the phasing plan of the payment for the required plant and machinery. This decision impacted the NPV however after renegotiations a better payment phasing plan was agreed upon which increased both the NPV and IRR. The internal investment strategies were analyzed to determine if the project would be greater than the financial assets of the comparable risk. This is accomplished by analyzing the risk of expanding market share of digital imaging versus entering the wireless communication market. When working through the scenario with a discount on the cash flow. The wireless communications project had an NPV of $14,026 and the digital imaging had an 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. SAI 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 SAI has to make.

4 Risk Analysis External Investment Strategy The external investment strategy proposed by SAI is W-Comm, an expansion into the wireless communication market. This proposal is a seven-year project, requiring an $18 million initial capital outlay at a cost of 18%, using an existing plant during the first three years, for production, producing 1,000 units per day. A new plant will be necessary by the third year. The new plant will require an additional capital outlay of approximately $16 million and will produce approximately 3,000 units per day. Competition and comparable products are some of the barriers. A good external investment strategy expected to increase revenue would be to merge or acquire another company in the same industry. SAI wants to generate additional revenue, which is the basic idea of an acquisition. Risk Analysis One of the risks of using NPV is the inability to account for uncertainty after the project decision has been made. In the simulation, several risks were presented. The final phase of the risk analysis is to adjust for project specific risks, equalizing time frames for the proposal, calculating the profitability index (PI) of the proposal, and final proposal selection. Each proposal poses different risks, however these risks do exist and they are uncertain. Due to this uncertainty the decision was made to set the risk premium equally at 3% for both of the proposals. The NPV yielded for the proposal for Dig-image and W-Comm were 2,513 and 8,750 respectively with IRR’s of 23.90% and 30.70% respectively. The decision was made not to equalize the time frame of the proposals. The PI for Dig-image and W-Comm was 1.06 and 1.34 respectively. Conclusion

5 Risk Analysis Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI) are tools used by Silicon Arts Inc. to make it easier for them to compare two capital investment proposals. SAI’s ultimate goal is to understand how the project will unfold under different probable scenarios maximizing shareholder wealth. Based on the analysis the best project would be the new market of wireless communications, W-Comm, using the existing building with little capital outlay. W-Comm has the highest NPV, IRR, and PI numbers.

6 Risk Analysis References University of Phoenix. (2009). Week Three Scenario: Silicon Arts, Inc. Retrieved March 16, 2009, from University of Phoenix, Week Three, rEsource, MBA540Maximizing Shareholder Wealth Course Web site