Mba_540_Week_3_Risk_Analysis

Running Head: RISK ANALYSIS ON INVESTMENT DECISION Risk Analysis on Investment Decision University of Phoenix Risk Analysis on Investment Decision Silicon Arts Inc. (SAI) “manufacturers digital imaging Integrated Circuits (IC's) used in digital cameras, DVD players, computers, and medical and scientific instrumentations” (University of Phoenix, 2009). In an effort to expand and remain competitive, SAI wants to increase market share and keep pace with today’s technology. SAI will analyze two capital investment proposals with a goal of selecting the project that generates the maximum value for the organization and investors. One proposal is an internal investment strategy, called Dig-image, which will expand the company’s existing digital imaging market share. The other proposal is an external investment strategy, called W-Comm, which will enter SAI into a wireless communication market. An analysis of the two capital project proposals by internal and external valuation techniques and risks associated with the proposed investment decision will be evaluated so the management and board of directors may make an informed decision. A part of the decision making process is to assess capital budgeting and spending associated with each proposal. The capital budgeting process will involve examining the cash flow projections, opportunity costs, net present value (NPV), internal rate of return (IRR), and profitability index (PI) for each proposal. External Investment Strategies An analysis of SAI’s external investment strategy proposal, W-Comm, shows that an expansion into the wireless communication market can increase revenue. The W-Comm proposal is a seven-year project, which requires an $18 million initial capital outlay with a cost of capital at18%, and will use an existing plant for production during the first three years producing 1,000 units per day. (University of Phoenix, 2009). Expansion into a new plant will need to happen by year three and “the expected capital outlay will be approximately $16 million. The new plant will produce 3000 units per day” (University of Phoenix, 2009). The projections are extremely promising and show the company continuing to build market share over the life of the project. The central idea of an acquisition or a merger is to generate greater revenue. SAI can generate this revenue by creating a good external investment strategy with W-Comm. An acquisition has four sources of synergy: “revenue enhancement, cost reduction, lower taxes, and lower cost of capital” (Ross, Westerfield, & Jaffe, 2005, p. 802). Although the external investment strategy proposal and the subsequent merger or acquisition of the other company is synergistic, the untested nature of the new technology may prove to be a burden to SAI. Internal Investment Strategies SAI’s internal investment strategy, Dig-image, is a proposal to expand its existing digital imaging market share. This five-year project proposes to open a new plant and requires a “capital outlay for the plant of approximately $40 million dollars with a cost of capital at 17%” (University of Phoenix, 2009). The land for the proposed plant was purchased in 2000 for $10 million; this is considered a sunk cost. This proposal is projected to “make a 30% contribution to SAI’s annual revenues during this period. The project is expected to generate revenues worth $54 million in year one through the sale of 400,000 semiconductor chips.” (University of Phoenix, 2009). Concerns affecting the Dig-image project involve using outside vendors and the payment plans for plant and equipment. SAI achieved a deal to pay for half in the first year and one fourth paid in years two and three. By breaking up the payments into successive years, SAI can manage its cash flow. When working through the scenario with a discount on the cash flow, the W-Comm project had a NPV of $14,026 with a rate of return of 32.00 and the Dig-image had a NPV of $5,448 with a rate of return of 23.40. (University of Phoenix, 2009). 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. (University of Phoenix, 2009). SAI assumed a risk rate of 3% and a risk-premium of 3% giving an estimate cost of equity capital of 1.38%. (University of Phoenix, 2009). SAI can use this information in analyzing the risk associated with its investment decisions. Risks Associated with Investment Decisions Being able to identify which proposal will generate the maximum value for SAI, it is necessary to analyze the risks associated with the investment decisions. These risks include initial tests, competition, comparable products, and price depreciation over the years. Calculations were made initially regarding NPV and capital outlay for the investments. One disadvantage or risk of using “NPV is the inability to account for flexibility or uncertainty after the project decision” (12manage, 2009). Besides a higher initial capital outlay for the internal Dig-image project over the external W-Comm project, the project life is shorter for the internal proposal. The risk involved in buying untested technology goes beyond the basic risk approach and uses the sensitivity analysis approach to analyze the impact of risk on capital budgets. “Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions” (Ross, Westerfield, & Jaffe, 2005, p. 214). The simulation permitted sensitivity analysis of NPV changes as a result of changes in cost of capital, cash flow and sales projections. In addition to predicting sales of either capital investment proposal, a big challenge faced by SAI is from tremendous amounts of competition. The forecast shows that the digital imaging market is growing and new companies are appearing to take part of the market share. Like any company trying to gain or maintain market share, SAI will need to stay ahead of the competition by using the mitigation technique of acquiring the competition. A concern about the competition also involves the risks of comparable products. With companies copying a profitable idea and making small changes to make the product different, the risks of comparable products are very high. A mitigation technique would be to constantly offer upgrades for the products that might introduce new features or simply make the product last longer and work better. Both the internal Dig-Image proposal and the external W-Comm proposal have something to offer but risk factors differ in both proposals. Dig-image is projecting a 25% increase in years two and three and a 15% increase in years four and five. After the fifth year, Dig-image might have a decrease of price in both intervals by 5%. Dig-image has a projected NPV of $13,827 and projected IRR of 30.50. W-Comm is projecting a15% increase in years two and three and a 10% increase in years four and five. After the fifth year, W-Comm might have a decrease of price in both intervals by 5%. W-Comm has a projected NPV of $13,991 and IRR of 31.30. Conclusion The opportunities to increase the shareholder’s wealth for SAI led to the development of two projects, Dig-image and W-Comm. Careful analysis using the external and internal investment strategies can help to analyze the risks associated with SAI’s investment decisions. In comparing the cash flow for both projects, the W-Comm project shows a more optimistic outcome of net cash flow for seven years with little capital investment, versus the Dig-image project cash flow for five years with larger capital investment. The analysis shows that the best project would be to go into the wireless communication market. References 12manage (2009). Net Present Value (NPV). Retrieved on October 30, 2009 from http://www.12manage.com/methods_npv.html Ross, S., Westerfield, R., & Jaffe, J. (2005). Corporate Finance (7th ed.). New York. The McGraw-Hill Companies. University of Phoenix. (2009). Week Three Scenario: Silicon Arts, Inc. Retrieved October 30, 2009, from University of Phoenix, Week Three, rEsource. MBA540 Maximizing Shareholder Wealth Course Web site.