Capital Budgeting

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.

Silicon Arts Incorporated (SAI) is a large manufacturing digital imaging company that used in digital cameras, DVD players, computers, and medical and scientific instruments and proved its sales all over the world. In year 2000, the company sales grew when semiconductor boom, but a year after its revenue fell due to the market crash. The CEO of the company named Hal Eichner has his own propaganda such as increase the market share and merge with wireless communication market.

The CEO should analyze and research the outcome of any changes within the organization before making any decisions. The authors of Merger and Acquisition mentioned that there are two bad reasons for mergers. First earnings growth is only accounting illusion (Jaffe, Ross, & Westerfield. pg. 8). Many companies in Wall Street nowadays are trap into profit shortfall in which stealing profits from the future that makes their present figure (cash) looks good in the eyes of investors or impress other ventures for the company to be sold. In reality, these public companies present their revenue as recognized in advanced even though the work is not completed.

Stockbrokers will present the as a growing company, which attracts many investors will bid their stock and has a positive outcome to the entity but not to shareholders. SAI need to think through when they had that decreased of sales how would the CEO report the losses in stock market. SAI should make better decision and not follow the path of WorldCom and Enron. Second, a diversification shareholder who wants to diversify can accomplish this at much lower cost with one phone call to their broker than can management with takeover (Jaffe, Ross, & Westerfield. pg. 8). Investors need to learn how to diversify their money in SAI since the company wants increase their market share. This means shareholders are responsible to diversify their money into stocks, bonds, real estate properties, and cash investments and not to depend on SAI stock market alone.

Internal Investment Strategies An internal investment strategy directs resources within the firm for research and development, adding employees, new plants and equipment to expand the firm's capacity, products, markets and capabilities. Strategic alliances may result in benefit to firms for the inter-firm collaboration inherent in the alliance (Sporleder & Peterson, 2003, pg 3). SAI evaluated whether increasing market share within their existing market of digital imaging was going to be financially wise decision in contrast to emerging into the new market of Wireless Communication. The Wireless Communication project had a net present value (NPV) of $12,881 with an internal rate of return (IRR) of 30.80. The Digital Imaging project had a NPV of $10,789 with an IRR of 29.10. It was assumed the risk premium was 2%. The profit index (PI) proved to be 1.22 and 1.39 for Digital Imaging and Wireless Communication, respectively.

Silicon Art s Inc. (SAI) has been researching different investment strategies for their company. They have been researching both internal and external strategies in order to determine what would be the most beneficial overall. Profit huge determining factor for SAI but they must look at both the long-term and short-term benefits of their decision. One route many companies look at when investing internally is expansion.

Expanding is one of the internal investment strategies that SAI is considering. SAI intends on expanding their company by adding a digital imaging plant. SAI needs to take a look at their operating leverage to make sure this plan is something they could afford. "Fixed costs do not change as quantity changes. Conversely, variable costs increase as the quantity of output rises. This difference between variable and fixed costs allows us to define operating leverage." (Jaffe, Ross, & Westerfield, 2005, p.328)

The operating leverage is so important to understand because it can help to determine what kind of risk SAI will be taking. "Business risk depends both on the responsiveness of the firm's revenues to the business cycle and on the firm's operating leverage." (Jaffe, Ross, & Westerfield, 2005, p.328). One of the reasons SAI is looking to add on new digital imaging plants is because they have already purchased the land and it would be considered a sunk cost for the company. With a sunk cost the company is not looking at investing any more money on land so therefore, they would be investing in something that they already started to invest in beforehand. The sunk cost lowers the amount of initial investment the company would have to make in their investment. The outcome would be looking at even less cost to their internal investment.

Analyzing Risk According to the authors of In any investment, an investor is exposed to several kinds of risks. The risks that SAI are associated with investments are liquidity risk or market risk, credit risk, operational risk, prepayment risk and extension risk (Jaffe, Ross, & Westerfield, 2005, pg. 423). Liquidity risk is often called, as marketability risks are an investment that are being traded and if cannot be sold this could causes the company's asset capital loss. Credit Risk is one of the major problem in most business today, SAI needs to take initiative to collect a possible debt obligations of their debtors in due time.

Operational risk is a threat of company's performance and their reputation is in the line. When acquiring a company the operational manager needs to have better and understanding of the new process so the result at the end would not be too costly. Pre-payment risk is when borrowers do not pay their portion. This would be too risky because the company can file bankruptcy of not collecting debt at all.

In increasing profit share and merging to another company this involves several risks to SAI. The company may experience financial crisis, bad decision-making, and profit loss. The CEO should make a plan or build a committee group on how to handle and prevent each risks so whatever the outcome as an entity they have an alternative solution to any problem. For instance, to hire a knowledgeable investor to handle the company's portfolio, chose the right product, and provide procedures to streamline the process.

Conclusion

Silicon Arts Incorporated is positioned to become an even larger presence in the electronics industry. With careful evaluation and consideration, the organization can choose the right product to develop in order to reach their goals. Internal and external investment strategies must be carefully evaluated and analyzed potential investment risks. By carefully evaluating all strategies and risks, SAI is on the brink of success to carry them into the future.

References

Capital Budgeting: Finance for Managerial Decision (2008). [University of Phoenix e- Text]. Retrieved July 13, 2008, from University of Phoenix, rEsource, MBA540 – Capital Budgeting Simulation Web site. Giddy Ian H., (2006). Methods of Corporate Valuation. Giddy.com. Retrieved July 11, 2008, from http://pages.stern.nyu.edu/~igiddy/valuationme thods.htm