Simulation: Capital Budgeting
Running head: SIMULATION: CAPITAL BUDGETING
Simulation: Capital Budgeting
Name
July 14, 2008
Introduction
Silicon Arts Incorporated (SAI) is a relatively new company whose specialty focuses on the manufacturing of digital imaging circuits used in different types of electronics. It has a somewhat global presence, operating in North America, Europe and South East Asia. Although the company’s annual sales turnover is $180 million, SAI has seen its revenues rise and fall with the industry’s fluctuations. SAI enjoyed tremendous growth, 78% following their industry boom (Capital Budgeting, 2008). However, shortly thereafter, revenues decreased by 40% as a result of industry slowdown (Capital Budgeting, 2008). As a result, SAI reduced costs and withheld on capital expenses. In response to the dramatic change in the market and in efforts to remain competitive, SAI decided to further invest in the research and development of a specialized chip. The specialized chip used in data embedded mobile phones resulted from SAI’s research and development efforts. Pilot tests of the chip showed positive results. With a gain in momentum in the industry, SAI has been able to record revenue growth in the last two quarters. The positive growth that SAI has been facing, the company has the opportunity to work with one of two companies that will potentially add to its value. As a result of the electronics industry and the investment decision made, SAI was well positioned going into 2002. Although SAI was well positioned at the start of 2002, executive management still has goals of increasing market share and keeping up with technology. SAI is contemplating expanding market share in the existing Digital Imaging or emerging into the Wireless Communication market (Capital Budgeting, 2008). To help SAI make a financially wise decision, internal and external investment strategies as well as the risk associated with the investment decisions were evaluated.
External Investment Strategies
In determining the suitability of each company, SAI used measures like Net Present Value (NPV), the project rate of return (IRR) and Profitability Index (PI) to compare the two investment proposals. Stakeholders in an organization invest their resources into a project that they expect will be profitable. The returns on these investments should be worth more than the cost. Managers of organizations make their investment decisions when the net present value is positive. Net present value is defined as the difference between the project’s value and its cost. In order to estimate what the return from a project is, SAI would need to know whether the project’s return is higher or lower than the opportunity cost of capital. The project rate of return is used to discount the project’s future cash flow. SAI’s objective is to invest in projects that offer a rate of return that is higher than the opportunity cost of capital. Mergers and Acquisitions (M&A) occur quickly, and the risks associated with M& A are high and often hidden. Unforeseen risks include environmental liabilities, management liabilities, political risks, and fiduciary and benefits liabilities which can jeopardize an M& A transaction. Another risk is not completely possible to eliminate bias from these analyses. The simulation showed, adjusting the approach (conservative, moderate or aggressive) changes the values of NPV, IRR and PI, such that the preferred proposal could favored. By being able to adjust the approach showed that it is possible to interject bias into the analysis. Making strategic decisions based on variable criteria is very risky. The reliability of these measures depends on the original assumptions regarding the cash flow projections. Using the appropriate measure is one risk mitigation method because it will reduce the level of risk involved. IRR and PI are more favored for smaller projects. The IRR rule also does not work when there are multiple changes in the cash flow. NPV is considered to be the most reliable criterion for project evaluation and is the best measure to base someone’s decision. Looking beyond the forecasts/estimates of future cash flows of capital investment proposals is one approach to mitigate the risk. Another risk mitigating approach would be to understand how the project would fare under the different probable scenarios. As shown in the scenario, different estimates of revenue or costs impact the measures. Every merger or acquisition brings with it some risk. These risks can be reduced by managers doing their due diligence. Failure of an M&A due to lack of due diligence or other external factors can be attributed to poor synergy, incompatible cultures, off-strategy decision-making, and bad timing.
