Microsoft Word - BioCom.docx
BioCom was founded in 1993, when several scientists and engineers at a
large fiber-optic-cable company began to see that optical fiber for the
telecommunications industry was becoming a cheap commodity. They
decided to start their own firm, which would specialize in cutting-edge
applications for research in the life sciences and medical
instruments. BioCom is now one of the leading firms in its niche
field. BioCom’s management attributes the firm’s success to its ability to
stay one step ahead of the market’s fast-changing technological
needs. Almost as important is BioCom’s ability to select high-value-added
projects and avoid commercial disasters.
Over lunch, BioCom’s director of research and development (R&D)
mentioned to the CFO that one of his best young scientists had recently left
the company because his line manager had rejected his project. Although
not a pattern, R&D had experienced similar losses in the past. The two
executives discussed the problem and agreed that if the R&D people
understood the selection process better, they might come up with more
commercially viable projects and understand the project’s financial
implications. The CFO has asked his assistant, Jane Donato, to prepare a
etreat for the R&D department to explain the company’s project selection
procedures. Jane is encouraged by the thought that this group will have no
trouble in following the math.
BioCom’s standard capital request form includes a na
ative description of
the project and the customer need that the company must fulfill. If the
equest originates with R&D, it then goes to the marketing department for a
preliminary sales forecast and then to the production manager and cost
analysts for cost estimates. If a proposal shows promise after these steps, it
goes to the CFO, who has a staff member enter the data into a spreadsheet
template. The template computes payback, discounted payback, net
present value, internal rate of return, and modified internal rate of
eturn. BioCom uses net present value as its primary decision criterion, but
company executives believe that the other statistics provide some useful
additional perspectives.
To explain BioCom’s capital budgeting techniques, Jane has decided to
present the cash flows from two recent proposals: the nano test tube project
and the microsurgery kit project. All figures are in thousands of dollars:
Time of Cash Flow Nano Test Tubes Microsurgery Kit
Investment ($12,000) ($12,000)
Year 1 2,000 5,000
Year 2 3,000 5,000
Year 3 4,000 5,000
Year 4 5,000 5,000
Year 5 7,000 5,000
Questions
1. Compute the payback period for each project.
2. Compute the discounted payback period for each project using a discount
ate of 10%
3. Compute the net present value (NPV) for each project. BioCom uses a
discount rate of 9% for projects of average risk.
4. Compute the internal rate of return (IRR) for each project.
5. Compute the modified internal rate of return (MIRR) for each project.
6. Explain to the R&D staff why Bio Com uses the NPV method as its primary
project selection criterion.
7. Explain the rationale behind the NPV method.
8. State and explain the decision rule for the NPV method.
9. Explain how the company would use the NPV method to rank mutually
exclusively projects.
10. Comment on the advantages and shortcomings of this method.
11. Without performing any calculations, explain what happens to the NPV if
the company adjusts the discount rate upward for projects of higher risk or
downward for projects of lower risk.