Flash Memory Inc. Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Approval of the project with respect to the Economic Perspective

Net Present Value (NPV) technique has been used to evaluate the investment; NPV is a capital budgeting method that is likely to be the most appropriate method of capital budgeting, which company can use in evaluating whether to invest or not in new capital investment. NPV is the present value of net cash inflows and cash outflows generated by a project including its salvage value. As it has been said earlier, NPV is the most-reliable technique to use in capital budgeting because it helps in maximizing shareholder value and it incorporates the time value of money by discounting all cash inflows and outflows. Before calculating net present value, the company sets a target rate of return that is company’s weighted average cost of capital, which is used to discount the net cash inflows arising from a project. The discount rate that is used to calculate present value is an important variable of this process. A company often uses its weighted average cost of capital after tax, but many analysts think that it is not appropriate and a company should be use higher discount rate than weighted average cost of capital because of risk of investment and other factors.

To compute the company’s weighted average cost of capital we have to compute the company’s cost of equity first. Flash Memory Inc. has used Capital Assets Pricing Model (CAPM) for calculating weighted average cost of capital; CAPM is used to determine the appropriate rate of return for a company’s equity holders. This model incorporates the systematic risk or market risk (systematic risk is vulnerability to event that affect the outcomes of investment), which is represented by beta equity. In addition, this model accounts for market expected return and the risk-free rate of return on theoretically risk-free assets such as government treasury bonds. Limitation of this model is that, it assumes that a company has well-diversified portfolio of investment; therefore, it does not incorporate unsystematic risk or non-diversifiable risk. Additionally, it is not easy to find an appropriate risk-free rate of return because risk-free rate of return vary with the number of years to yield to maturity of government treasury bonds.

The CAPM formula is:

Where:

Rf= Risk free rate of return

Rm= Market rate of return

Be= Measure systematic risk and known as Equity Beta

(Rm-Rf)= Equity risk premium

Flash Memory Inc. is considering the new product line. The new product line had been in development for the past nine months, and $400,000 had already been spent for taking the product from the concept stage to the point where working prototypes had been built and they are currently being tested. To evaluate the net present values, only relevant cost has been considered that are specific to management's investment decisions. For example, sunk cost has been ignored, which is a cost that has been already incurred and will not recover either we invest in the project or not therefore these $40,000 that have already been spent in the last nine months is an irrelevant cost and has not been incorporated while calculating the net present value. In addition to this, depreciation of property, plant and equipment is a non-cash expense, which is already included in the cost of sales; therefore, we have added it back after taxable profits because it is also an irrelevant cost. It is assumed that sales to be at least $21.6 million in 2011 and $28 million in 2012 and 2013, before falling off to $11 million in 2014 and $5 million in 2015. Customer acceptance and competitor reaction to the new product line was uncertain; therefore, estimation of sales revenue should be measured reliably and the marketing team should estimate sales revenue in more depth and should consider all risk factors. It assumed that the working capital will be incurred in the first year of operation i.e. 2011, so the working capital is assumed to be 26.15% of sales revenue. Moreover, net working capital will increase and then decrease as sales of the new product line rise and then fall. Full amount of working capital will be recovered at the end of the project life. It is assumed that investment of $300,000 in advertising and promotion campaign simultaneous with the launch of the product in 2011 is a relevant cost because it arises due to this project; therefore, it has been incorporated in the project.................................

This is just a sample partial case solution. Please place the order on the website to order your own originally done case solution.