Solutions for BioCom, Inc. Minicase

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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 retreat 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 narrative description of the project and the customer need that the company must fulfill. If the request 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 return. 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

-$11,000

-$11,000

Year 1

2,000

4,000

Year 2

3,000

4,000

Year 3

4,000

4,000

Year 4

5,000

4,000

Year 5

7,000

4,000

Help Jane answer the following questions.

Questions:

Compute the payback period for each project.

  1. Explain the rationale behind the payback method.
  2. State and explain the decision rule for the payback method.
  3. Explain how the payback method would be used to rank mutually exclusive projects.
  4. Comment on the advantages and shortcomings of this method.

Compute the discounted payback period for each project using a discount rate of 10%.

  1. Explain the rationale behind the discounted payback method.
  2. Comment on the advantages and shortcomings of this method.

Compute the net present value (NPV) for each project. BioCom uses a discount rate of 9% for projects of average risk.

  1. Explain the rationale behind the NPV method.
  2. State and explain the decision rule behind the NPV method.
  3. Explain how the NPV method would be used to rank mutually exclusive projects.
  4. Comment on the advantages and shortcomings of this method.
  5. Without performing any calculations, explain what happens to NPV if the discount rate is adjusted upward for projects of higher risk or downward for projects of lower risk.

Compute the internal rate of return (IRR) for each project.

  1. Explain the rationale behind the IRR method.
  2. State and explain the decision rule behind the IRR method. Assume a hurdle rate of 9%.
  3. Explain how the IRR method would be used to rank mutually exclusive projects.
  4. Comment on the advantages and shortcomings of this method.

Compute the modified internal rate of return (MIRR) for each project.

  1. Explain the rationale behind the MIRR method.
  2. State and explain the decision rule behind the MIRR method. Assume a hurdle rate of 9%.
  3. Explain how the MIRR method would be used to choose between mutually exclusive projects.
  4. Explain how this method corrects for some of the problems inherent in the IRR method.

Explain to the R & D staff why BioCom uses the NPV method as its primary project selection criterion.

Challenge question. Construct NPV profiles for both projects using discount rates of 1% through 15% at one percentage point intervals. At approximately what discount rate does the Nano test tube project become superior to the micro surgery kits? This problem is best solved using an electronic spreadsheet.

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