Apex Semiconductor Inc. (ASI) is evaluating two proposed projects, Sand L.Table

Question

Apex Semiconductor Inc. (ASI) is evaluating two proposed projects, Sand L.Table 1 provides some simplified data on two projects. Both involve developing a new computer chip, but with different ways of handling the operation. Under plan S, the project would be accelarated; hence itwould have high sales in Year 1. However, under Sthe firm's competitors would learn aboutthe product relatively soon, and sales would decline as competitors began to produce similar chips. Therefore, S's cash flows decline over its 4-year life. Under Project L, things would be handled differently. Here, PNC would operate slowly, carefully, and securely, and customers would be locked in through long-term contracts. Thus under L, sales and cash flows would rise over time. Even so, new products would eventually replace this chip, so L would also have a 4-year life. Financial analysts have estimated ASI's weighted cost of capital (WACC) to be 8.71%. Table 1. Cash Flows for Projects S and L Project S Year (t) Net cash flow Proiect L Year (t) Net cash flow ($100,000 $10,000 20,000 $50,000 $75,750

Explanation / Answer

1. Payback period is number of years it takes ti recover the initial cost of an investment.

For project S Initial investment is $100,000.

Year 1 inflow = $ 82270.

Year 2 Inflow = $ 30000

Now after year 1, unrecovered investment amount is = 100,000 - 82270 = $ 17,730.

Now during year 2 Project S will have $ 30000 as annual inflow over 12 months. So to recover additional inflow of 17730, it would take

Time = 17730/30000 = 0.59 years.

Payback Period = 1.59 years for Project S.

2. For Project L, initial investment is $ 100,000

During First 3 years, project L will receive total inflow of 80000 $

Now after end of 3 years, unrecovered investment is $ 20000

In 4th year, project L will receive 75750$ of inflow.

so to recover 20000 it will take 20000/75750= 0.2640 years

So payback period for Project L = 3.2640 years

Now we shall calculate discounted pay back period. For that, we shall compute Discounted Cash Flow with WACC of 8.71%

Now we shall use the same formula for payback period to determine discounted payback period for S and L

Now for S initial investment is 100000 $. It will recover 75680.17 $ in first year. so remaining unrecovered investment is 24319.83. To recover this amount, in year 2 it will take time = 24319.83/25386= 0.9580 years

So discounted payback period for Project S is 1.9580 years.

Now for Project L, initial investment is 100000 $. Now recovery in first 3 years as per discounted cash flow is 63043 $. So unrecovered investment is $ 36957.

In 4th year, project L will receive discounted cash flow of $ 54237.

So for recovery of 36957, it will take 0.6814 years (36957/54237)

Accordinly, discounted pay back period for Project L is 3.6814 years.

Year 1 Year 2 Year 3 Year 4 Project S 82270 30000 10000 10000 Project L 10000 20000 50000 75750 Discount Factor 1/1.0871 1/(1.0871)^2 1/(1.0871)^3 1/(1.0871)^4 Discount Factor 0.9199 0.8462 0.7784 0.7160 Discounted Cash Flow S 75680.17 25386.00 7784.00 7160.00 Discounted Cash Flow L 9199.00 16924.00 38920.00 54237.00

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