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A1 ACC00152 S3 2015

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ACC00152 Business Finance

Assignment 1: Memo to Management

After spending $2 million in research and development expenditure over the past 6 months, ABC Ltd

has developed a new mobile device accessory. ABC’s directors are excited about the new product

but now need to choose between three options for taking the product to market.

Option 1

ABC has traditionally focused on research and development projects in which the finished product

design is sold or licensed to other companies. However, the Board of Directors wants to explore the

viability of ABC manufacturing and selling the accessory itself.

Two months ago, ABC paid an external consultant $200,000 for a production plan and demand

analysis. The consultant recommended producing and selling the product for five years only as

technological change will likely render the accessory obsolete after that time. Sales of the accessory

are estimated as follows:

Year Estimated sales volume

(millions of units)

1 1.5 2 2.0 3 2.5 4 1.8 5 1.0

In the first year, it is estimated that the accessory will be sold for $20 per unit. However, the price

will drop in the following three years to $18 per unit and fall again to $10 per unit in the final year of

the project, reflecting the effects of anticipated competition and better models in the market.

Variable production costs are estimated to be $10 per unit for the entire life of the project. Fixed

production costs (excluding depreciation) are predicted to be $2 million per year and marketing

costs will be $1.5 million per year.

Production will take place in factory space the company owns and currently rents to another

business for $500,000 per year. Equipment costing $12 million will have to be purchased. ABC will

depreciate this equipment for tax purposes using a prime cost rate of 20% per annum (applied to the

equipment cost) and at the end of the project expects to be able to sell the equipment for

$2.5 million.

Investment in net working capital will also be required. It is estimated that accounts receivable will

be 5% of sales, while inventory and accounts payable will each be 10% 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.

A1 ACC00152 S3 2015

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Option 2

XYZ Ltd has expressed an interest in manufacturing and marketing the accessory under license for 5

years. For each unit sold, XYZ will pay a $3 royalty to ABC as part of its licensing agreement. Due to

XYZ’s international reach and strong distribution networks, it is estimated that they can sell 10%

more units each year than ABC.

Option 3

As an alternative to a licensing arrangement, XYZ Ltd has offered to buy the patent rights to the

accessory design from ABC for $24 million. This amount would be paid in two equal instalments, the

first payable immediately and the second at the end of two years.

General Information Relevant to the Analysis

ABC’s cost of capital is 10% 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), ABC is expected to have other

sources of taxable income.

Your Task

Your boss, ABC’s CFO John Smith, has asked you to analyse the three options and draft a memo to

the Board of Directors providing recommendations on the alternatives, along with supporting

analysis.

John has outlined three areas that you must cover in your memo:

1. analyse base case figures for the three options and use NPV as the 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 new accessory (but you do not have to undertake further analyses).

He has also asked that you structure your memo to begin with a (maximum) one page summary of

your method, key findings and recommendations, supported by no more than three additional pages

showing input assumptions, estimated cash flows and supplementary analysis detail and discussion.

Table format for presenting numerical analyses is preferable. Ensure that readers will be able to

easily follow what you have done. You may wish to use footnotes under tables that clarify

calculations, details and/or assumptions where this is not clear from the table itself.

Marking Criteria

This assignment has a 20% weighting in your overall mark for this unit. It will be marked out of 20.

Marks will be allocated as follows:

 Accurate analysis of base case figures (12.5 marks)

 Sound recommendations on the alternatives founded on base case analyses (1.5 marks)

 Insightful recommendations for further considerations prior to final decision (4 marks)

 Memo format and professionalism of communication (2 marks).