Risk Analysis on Investment Decision Sai

Capital Budgeting Simulation

By:

Letitia Hoch

University of Phoenix

Introduction

Silicon Arts Inc, (SAI) is a 4 year old company that manufactures digital imaging integrated circuits (University of Phoenix, 2007). These circuits are used in digital cameras, DVD players, computers, and many instruments used in the medical and scientific world. SAI is a global company with North America accounting for 70% of their sales, Europe accounts for 20% of sales, and South East Asia accounts for a mere 10% of total sales (University of Phoenix, 2007). Over the past several years, SAI has had strong growth and has had big losses due to changes in the market and economy. All during this time, new technologies were being researched and the IC 1032 chip was developed. This chip could promote internal growth if it was able to generate sales. This chip works in data embedded mobile phones, and pilot testing showed good results with the chip. In 2002, SAI had very strong financial positioning and the board of directors made the decision to promote growth either internally or externally.

Growth Options

SAI has ideas for growth to occur in two possible ways. One option will increase market share by raising production of already existing products and the other will cause growth through internal channels by entering a new market with the IC 1032 chip (University of Phoenix, 2007). The first option to be analyzed is that of internal growth. Cash flow would be invested in internal growth projects by working with another company, Dig-Image. This company would use their existing plant in Sunnyvale California and would begin manufacturing all of SAI’s current products on a much larger scale. This option boasts a growth of 20% over the first year with 7% annually for the life of the project. The project is estimated to have a life of 5 years.

The second project would be an external project as SAI would begin providing their IC 1032 chip for digital phone users. By entering the communications market, SAI would have the means to capture revenue from a different market altogether. Either way, growth should occur. It is estimated that 12.5 million telephone headsets will need SAI’s technology and that 3-4% of the global community will get that technology from SAI in the first 4 years with continued percentage growth through the end of the project at year 7.

Choice Factors

In order to recognize risk and to see which option would be of greatest value to SAI, several analysis pages should be reviewed. This will give SAI values for the Net Present Value (NPV) of both companies. This number estimates the worth of the company by finding the difference between the company’s value and costs (Ross, et al, 2004). A higher NPV usually signifies the best project. NPV values are considered the most valuable criteria when picking between two mutually exclusive projects. Internal Rate of Return (IRR) tells if the projects return is higher than the opportunity cost of capital. The IRR should be higher than the opportunity cost for a good project (Ross, et al., 2005). The Profitability Index (PI) tells investors the amount of return to expect for every dollar invested in the company. The higher the PI value and IRR value, the better the project is estimated to be, but both PI and IRR tend to favor smaller projects so the NPV remains the most needed figure (Ross et al., 2004).

Choice

After all figures were considered the NPV, IRR, and PI of each company was evaluated. These were figured with the financial statements of present cash flow and expected expenses, costs, revenue, and losses. In all three areas; NPV, IRR, and PI, W-Comm had the highest values. This would suggest that branching out externally into the digital communications business with W-Comm support would have better value than picking the internal project with Dig-Image to increase production.

Risk

The risks associated with the proposal for joining W-Comm by offering the IC 1032 chip for digital communications, are as follows: There is a lot of intense competition in the communications business. Companies’ value can be eroded away by companies selling comparable items to the IC 1032 chip. The only way to mitigate this risk is to continue to funnel money into the R& D department so that new technologies are created and added as soon as possible.