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Your boss, SSF's CFO Savanah Harley, has asked you to evaluate the three different options and draft a memo to the Board of Directors providing recommendations on the alternatives, along with supporting analysis.
Savanah has outlined the following three areas you need to cover in your memo:
- Analyse base case figures for the three options and using NPV as the investment decision rule; 2. Provide recommendations based on the base-case analyses;
- Provide recommendations on further analyses and factors that should be considered prior to making a final decision on the three options (Note. You do NOT have to undertake any further financial analyses).
Further details for the various options are as follows:
Two months ago, SSF paid an external consultant $800,000 for a production plan and demand analysis. The consultant recommended producing and selling the product for five years only as technological innovation will likely render the market too competitive to be profitable enough after that time. Sales of the product are estimated as follows:
volume (000's of units)
In the first year, it is estimated that the product will be sold for $90,000 per unit. However, the price will drop in the following three years to $75,000 per unit and fall again to $50,000 per unit in the final year of the project, reflecting the effects of anticipated competition and improving technology in the market. Variable production costs are estimated to be $45,000 per unit for the entire life of the project.
Fixed production costs (excluding depreciation) are predicted to be $9.5 million per year and marketing costs will be $8 million per year.
Production will take place in factory space the company owns and currently rents to another business for $5.5 million per year. Equipment costing $80 million will have to be purchased. This equipment will be depreciated for tax purposes using the prime cost method at a rate of 20% per annum. At the end of the project, the company expects to be able to sell the equipment for $8 million.
Investment in net working capital will also be required. It is estimated that accounts receivable will be 25% of sales, while inventory and accounts payable will each be 20% of variable and fixed production costs (excluding depreciation). This investment is required from the beginning of the project because credit sales, inventory stocks and purchases on trade credit will begin building up immediately. All
accounts receivable will be collected, suppliers paid and inventories sold by the end of the project, thus the investment in net working capital will be returned at that point.
Aero Jett Inc., a multinational corporation, has expressed an interest in manufacturing and marketing the product under license for 5 years. For each unit sold, Aero Jett will pay $11,200 royalty fees per unit to SSF as part of its licensing agreement. Due to Aero Jett's international reach and strong distribution networks, it is estimated that they can sell 15% more units each year than SSF.
As an alternative to a licensing arrangement, Aero Jett Ltd has offered to buy the patent rights to the product design from SSF for $120 million. This amount would be paid in three equal annual instalments, with the first payable immediately.
Option A: Manufacturing the product 'in-house' and selling directly to the market
- Financial analysis shows that the company would have to pay taxes at 30%.
- The NPV calculation also shows that as long as the sales and revenue actuals are according to the projections made, then the project would be beneficial.
- However, the other two options also have to be computed.
The Profits are calculated based on sales made for 5 years.
Since there would be no production or marketing costs, the NPV is seen to be higher than Option A.
Other than the royalty, they will also be gaining by renting out the production floor space. In Option A, since the company would be using the space for their own production, this rent foregone is an Opportunity cost. Although that has not been included in the computation, it would still be a qualitative factor to be considered.
Applying the formula for NPV in Option B, the value would be $91,720,842.85