ACC00152 Business Finance

Assignment 1: Memo to Management

You are working in the finance department of Space Sky Flight Ltd (SSF). The Company has spent $6.5 million in research and development over the past 12 months developing a drone capable to fix satellites to compete in the space industry. SSF’s directors now need to choose between three options for bringing this product to the market. These options are:

Option A: Manufacturing the product “in-house” and selling directly to the market
Option B: Licensing another company to manufacture and sell the product in return for a royalty Option C: Sell the patent rights outright to the company mentioned in option B

Your task

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:

1. 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;
3. 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:

Option A

Two months ago, SSF paid an external consultant $950,000 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:

Year

Estimated sales volume (000’s of units)

1

4

2

3.5

3

5.5

4

3

5

1.5

 

In the first year, it is estimated that the product will be sold for $110,000 per unit. However, the price will drop in the following three years to $70,000 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 $35,000 per unit for the entire life of the project.

Fixed production costs (excluding depreciation) are predicted to be $11.5 million per year and marketing costs will be $9.5 million per year.

Production will take place in factory space the company owns and currently rents to another business for $7.5 million per year. Equipment costing $275 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 $55 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.

Option B

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 $8,250 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 5% more units each year than SSF.

Option C

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.

General Information Relevant to the Analysis

SSF’s cost of capital is 16% and the company is subject to a 30% tax rate. Assume that royalties and patent right payments are treated as assessable income for tax purposes and that tax is paid at the end of the year in which the income is received. The company is not eligible for any research and development tax deductions. During the project analysis period(s), SSF is expected to have other sources of taxable income.

 

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