Risk Analysis

Risk Analysis on Investment Decision

Silicon Arts, INC. (SAI) is a four year old company that manufactures digital imaging integrated Circuits (IC's) that are used in digital cameras, DVD players, computers, and medical and scientific instruments. Hal Eichner, SAI's Chairman, has a two-point agenda for the company to increase market share and keep pace with technology. As the Financial Analyst for the company one must analyze two mutually exclusive capital investment proposals. The two options are to expand the existing Digital Imaging market share or enter the Wireless Communication (W-Comm) market.

Shareholders in organizations like to invest in 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 p166). The investment in net working capital is an important part of any capital budgeting analysis. "The sensitivity analysis is one approach (a.k.a. what-if analysis and bop analysis1), which examines how sensitive a particular Net Present Value (NPV) calculation is to changes in underlying assumptions" (Ross 2005 p169).

"Another approach is the break-even analysis. As its name implies,

this approach determines the sales needed to break even. The

approach is a useful complement to sensitivity analysis, because

it also sheds light on the severity of incorrect forecasts. We calculate

the break-even point in terms of both accounting profit and present

value" (Ross 2005 p 216).

In order to complete an analysis the Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI) will be calculated. The difference between the project's value and cost is the NPV. "IRR always reaches the same decision as NPV in the normal case where the initial outflows of an independent investment project are only followed by a series of inflows" (Ross 2005 p168). In order to come to the final NPV, IRR and PI the cashflow statements will be analyzed. This will be accomplished by examining the assumptions made while predicting sales, price and marketing costs for the proposals. Checking with the capital expenditure schedules planned is optimal and accounting for hidden cashflows. Finally, accommodating for the risks inherent in the proposals and leveling the cashflow streams of the two proposals using Annuity calculation are imperative. Once all the steps are completed the proposal with the highest NPV, IRR and PI values should be chosen.

A recent worldwide study has forecasted that the Digital Imaging semiconductor market will grow 20% in Year One. The demand will grow seven percent annually from Year Two onwards. By Year Five, new technologies will take over the market. SAI plans to generate $54 million in Year One form the sale of about 400,000 units. The life of the project would be five years. Entry barriers are intense competition and price war, prices to go down five percent annually in year two and three and in years four and five prices are expected to fall as well. Marketing costs to go up to five percent of sales in years one, two and three as chip manufactures need to develop a powerful branding strategy.

The W-Comm industry estimates say that about 25 million mobile handsets would be sold in Year Three. Year One would be sales for SAI would be relatively small, at around 175,000 units. Sales are expected to grow in excess of 15% in years two and three. SAI can target to capture three to four percent of the global market by year four. The market is expected to grow 10% annually between years four and seven. Entry barriers are the competition and comparable products to IC1032. The competition and comparable products will cause prices to fall five percent

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