Silicon Arts Inc

Silicon Arts Inc.,

Analysis of Dig-Image and W-Comm projects

MBA 540

December 4, 2007

University of Phoenix Online

Silicon Arts Inc. Analysis of Dig-image and W-Comm projects

Silicon Arts Inc. (SAI) is a manufacture of digital imaging Integrated Circuits (IC) that are used in digital cameras, DVD players, computers, medical and scientific instrumentation. The major sales are in North America but the company has presence in Europe and South East Asia. SAI grew rapidly in the first years due to the semiconductor industry boom. As the industry began to slow down, SAI watched their revenues fall by 40%. SAI survived the decrease in revenues by cutting costs and freezing capital expenses. Wisely, SAI continued its research and development efforts and developed the IC 1032 - a specialized chip used in data embedded mobile phones (University of Phoenix, 2007).

Hal Eichner, SAI Chairman, has a two point agenda for the company; increase market share, and keep pace with technology. The management team has developed two project proposals to accomplish the company's goals. The proposals are to expand the Digital Imaging (Dig-image) market share or enter the Wireless Communication (W-Comm) market. The goal is to increase the shareholder's wealth by selecting the appropriate project. Shareholders like to invest in capital projects that are worth more than they cost. "In capital budgeting, the profitability index measures the bang (the dollar return) for the buck invested. Hence, it is useful for capital rationing" (Ross, 2005). An analysis of the two projects will be evaluated so that the Board of Directors and shareholders may make an informed decision. In order to complete the analysis, the Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability (PI) will be calculated in three parts of the project.

Operating Cash Flow

The first part is to examine the probable future that could potentially affect the cash flows for SAI and from the respective projects, Dig-image and W-Comm. The Dig-image proposal is expected to generate revenues of $54 million in Year 1. The capital outlay of the plant is $40 million. The cost of capital is 17%. "Working capital rises over the early years of the project as expansion occurs. However, all working capital is assumed to be recovered at the end" (Ross, 2005). The project is estimated to be a five-year term and will contribute 30% to SAI's annual revenues during this period. Although increasing production and increasing the units sold will increase the IRR and NVP, SAI would be taking the risk that the price will drop and technology will change possibly before lifespan of the project.

The W-Comm project will use existing real estate at the Santa Clara plant for the first three years. The capital outlay for the initial project is $18 million for the first three years and another $16 million in Year 3 from a new plant in Sunnyvale. With the W-Com venture, it is estimated that SAI will capture 3-4% of the 12.5 million handsets sold by year 4 and will continue to increase over the life of the project. Even though test trials of the IC 1032 chip looks promising, SAI would be taking the risk that the chip may not fulfill performance and leave the door open for competitors.

To compare the two projects according to the working capital model the CFO will need to make use of the IRR and NVP. "Through NVP is the best capital budgeting approach conceptually, it has been criticized in practice for providing managers with a false sense of security" (Ross, 2005). The overall strategy yield for the operating cash flow of the two projects are Dig-image NVP is 17,752 (000) and IRR is 32.90%, W-Comm NVP is 12,018 (000) and IRR is 29.60%. Refer to table 1

Capital Expenditures

The second part of the evaluation process includes analyzing the capital expenditure for the plant, machinery and technology required at the factory. For the Dig-image project, the machinery may be purchased from the existing vendor, Hathaway Industrial Systems, or from a multinational turnkey contractor, J&T. Through tough negotiation J&T is able to offer a better future with the NVP of 5,515 and an IRR of 23.70% as opposed to Hathaway's contribution NVP of 3,184 and IRR of 21.80%. Arrangements were made to have a split phase payment, at 50% at Year 1 and 25% for Year 2 and Year 3. This is a better option to break up the payment into successive years than to have the cash flow severely decreased in the first year. It was decided to salvage the value of the equipment at the end of its useful life of five years.

For the W-Comm project in developing the IC 1032, the decision is to use In-house R&D or to buy out DigIC, owned by Gus Longman. The original decision was to choose the In-house R&D because Longman's technology was expensive and relatively untested. Longman made a new deal of 60% payment up front and the remaining 40% as a yearly retaining fee. The yearly retainer fee has been considered at a rate of 4% inflation for the life of the project. This positively affects the NVP and IRR. For the buy out of DigIC, the NVP for SAI is 15,870 and the IRR is 33.40% as opposed to the In-house contributing the NVP of 15,318 and the IRR of 32.50%. It was decided that there would be a terminal value associated with the purchase that was determined to be 5% of the Capex.

For the capital expenditure proposals, Dig-image NVP is 17,255(000) and IRR is 34.10% and W-Comm the NVP is 12,909(000) and the IRR is 30.90%. Refer to table 2

Risks, Equalizing time frames and Profitability Index

The last part involves adjusting the project for specific risks, equalizing time frames for the proposals and calculating the Profitability Index for the individual projects. "The Profitability Index is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment" (Ross, 2005) Many risks exist for each project and need to be factored in. The market share of SAI is competitive and has an associated