Assignment 1: Memo to Management
Widget Ltd has developed a new cloud-based service for network managers called ViewAll that continually monitors a network and displays the results in a handy mobile dashboard. Over the past year, the company has paid $5 million to research and develop the technology underlying the software and service model. With research and development now complete, Widget’s directors must decide the way forward. Macrosoft has offered to buy the patent rights to ViewAll from Widget. This sale would result in an immediate net cash flow of $15 million after taxes. In the past, Widget has usually taken up such offers. However, this time the Board of Directors wants to explore the viability of Widget running the ViewAll service itself, rather than selling it.
Last month, Widget paid an external consultant $200,000 for a demand analysis of the ViewAll service. The consultant recommended a five year life for the service because competition and technological change will likely render the service obsolete after that time. Revenue for the service will come in the form of subscriptions to users. Subscriptions are estimated as follows:
Year Estimated subscription volume
In the first year, the price of a subscription will be $200 per annum and increase to $250 in the second year. Predicted competition in the market for the final three years of the project will necessitate maintaining the subscription price at the year 2 level. Variable service costs are estimated to be $40 per subscription for the entire life of the project. Additional fixed costs (excluding depreciation and marketing) for the project are predicted to be $10 million per year and project marketing costs will be $15 million per year.
Equipment costing $12 million will have to be purchased. Widget 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 million.
Investment in net working capital will also be required. It is estimated that accounts receivable will be 10% of annual sales, while accounts payable will be 5% of total annual variable and fixed costs (excluding depreciation). Inventory will be negligible for the ViewAll service. The investment in net working capital will be required from the beginning of the project because credit sales and purchases will begin building up immediately. All accounts receivable will be collected and suppliers paid by the end of the project, thus the investment in net working capital will be returned by the end of the project’s final year.
Widget’s cost of capital is 10% and the company is subject to a 30% tax rate. Assume 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), Widget is expected to have other sources of taxable income.
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A1 ACC00152 S1 2017
Your boss, Widget’s CFO Diane Jones, has asked you to analyse the project and draft a memo to the Board of Directors providing recommendations, along with supporting analysis.
Diane has outlined three areas that you must cover in your memo:
1. Estimation of the project’s base case NPV, with associated supporting detail;
2. Recommendation on the project based on the base-case analysis;
3. Recommendations on further analyses and factors that should be considered prior to making a final decision on ViewAll (but you do not have to undertake further analyses).
She 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.
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 (11.5 marks)
• Sound recommendation founded on base case analysis (1.5 marks)
• Insightful recommendations for further considerations prior to a final decision (5 marks) • Memo format and professionalism of communication (2 marks).