Question

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 B: Licensing another company to manufacture and sell the product in return for a royalty 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). 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 $4,450 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. General Information Relevant to the Analysis SSF's costofcapitalis 16% and the company is subject to a 30% tax rate. Assume that royalties and patentrightpayments are treatedasassessable income fortaxpurposes and thattaxis paid atthe end of the year in which the income is received. The company is not eligible for any research and developmenttax deductions. During the project analysis period(s), SSF is expected to have other sources of taxable income.

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 $80,000 per unit and fall again to $60,000 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 $10.5 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

$7 million per year. Equipment costing $300 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 $75 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 $4,450 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 $60 million. This amount would be paid in three equal annual instalments, with the first payable immediately.

Answer 1

NPV - Option A

							($ in million)
Year	0	1	2	3	4	5	Remarks/ calculation
Sales		440.0	280.0	440.0	240.0	90.0	Units X Rates
Variable costs		(180.0)	(157.5)	(247.5)	(135.0)	(67.5)	Units X Variable cost per unit
Fixed production cost		(10.5)	(10.5)	(10.5)	(10.5)	(10.5)
Marketing cost		(8.0)	(8.0)	(8.0)	(8.0)	(8.0)
Rent income forgone		(7.0)	(7.0)	(7.0)	(7.0)	(7.0)
Equipment costing	(300.0)					75.0
Working capital - accounts receivable	(372.5)					372.5	20% to total sales for 5 years
Working capital - inventory	(168.0)					168.0	20% to total variable and fixed cost for 5 years
Working capital - Accounts payable	168.0					(168.0)	20% to total variable and fixed cost for 5 years
Tax outflow		(56.9)	(15.6)	(36.6)	(10.4)	-	As per calculation below
Net cash flows (A)	(672.5)	177.7	81.4	130.4	69.2	444.5	Sum of above
PV Factor @ 16% (B)	1	0.862	0.743	0.641	0.552	0.476
Discounted cash flows	(672.5)	153.1	60.5	83.5	38.2	211.6	A X B
Net Present value						(125.5)	Sum of discounted cash flows
Computation of tax outflow
Year		1	2	3	4	5	Remarks/ calculation
Sales		440.0	280.0	440.0	240.0	90.0
Variable costs		(180.0)	(157.5)	(247.5)	(135.0)	(67.5)
Fixed production cost		(10.5)	(10.5)	(10.5)	(10.5)	(10.5)
Marketing cost		(8.0)	(8.0)	(8.0)	(8.0)	(8.0)
Reduction in rental income		(7.0)	(7.0)	(7.0)	(7.0)	(7.0)
Depreciation		(45.0)	(45.0)	(45.0)	(45.0)	(45.0)	(Cost - Salvage value) X 20%
Net income		189.5	52.0	122.0	34.5	(48.0)
Tax @ 30%		56.9	15.6	36.6	10.4	-

NPV - Option B

							($ in million)
Year		1	2	3	4	5	Remarks/ Calculation
Revised sales units (In nos)		4,200	3,675	5,775	3,150	1,575	Sales units + 5%
Royalty fees		18.69	16.35	25.70	14.02	7.01	4450 X Sales units
Tax on Royalty fees		(5.6)	(4.9)	(7.7)	(4.2)	(2.1)
Net cash flows (A)		13.1	11.4	18.0	9.8	4.9	Royalty fees - Tax
PV Factor @ 16% (B)		0.862	0.743	0.641	0.552	0.476
Discounted cash flows (A X B)		11.3	8.5	11.5	5.4	2.3
Net Present value						39.1	Sum of discounted cash flows

NPV - Option C

				($ in million)
Year	0	1	2	Remarks/ Calculation
Patent rights payments	20.0	20.0	20.0	60 divided equally
Tax on Royalty fees	(6.0)	(6.0)	(6.0)
Net cash flows (A)	14.0	14.0	14.0
PV Factor @ 16% (B)	1	0.862	0.743
Discounted cash flows (A X B)	14.0	12.1	10.4
Net Present value			36.5	Sum of discounted cash flows

Recommendation:

After analyzing all the 3 options, we understand that, OPTION B i.e Royalty from Aero Jett Inc is most profitable with highest NPV of 39.1 mn $.

In option A of own manufacturing there is a loss as it has negative NPV of 125.5 $ mn