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.

Marking Criteria

Your boss has 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 30% weighting in your overall mark for this unit. It will be marked out of 30. Marks will be allocated as per rubric on following page based on:

- Accurate analysis of base case figures (18 marks)

- Sound recommendations on the alternatives founded on base case analyses (1.5 mark) - Insightful recommendations for further considerations prior to final decision (7.5 marks) - Memo format and professionalism of communication (3 marks).

Marking Rubric for ACC00152 S1 2018 Assignment

MARKING CRITERIA Excellent Very Good Good Fair Poor

Accurate analysis of base case figures for Option A (13.5 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option A (13.5 marks) You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option A (10-13 marks) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option A (7-9.5 marks) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option A (3.5-6.5 marks) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option A (0-3 marks)

Accurate analysis of base case figures for Option B (3 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option B (3 marks) You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option B (2-2.5 marks) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option B (1-1.5 mark) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option B (0.5 mark) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option B (0 mark)

Accurate analysis of base case figures for Option C (1.5 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option C (1.5 marks). You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option C (1 mark) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option C (0.75 mark) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option C (0.5 mark) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option C (0 mark)

Sound recommendations on the alternatives founded on base case analyses (1.5 mark) You have made a recommendation for A, B or C applying the NPV investment decision rule (1.5 mark). You have made a recommendation for A, B or C applying the NPV investment decision rule (1 mark). You have made an attempt to make a recommendation for A, B or C applying the NPV investment decision rule (0.75 mark). You have made an attempt to make a recommendation for A, B or C applying the NPV investment decision rule (0.5 mark). No recommendations made (0 mark).

Insightful recommendations for further considerations prior to final decision (7.5 marks) Using results from your quantatative analysis of the data, your recommendations are insightful and demonstrate a critical application of techniques used in the capital budgeting process (7.5 marks). Using results from your quantatative analysis of the data, your

recommendations are considered and demonstrate a reasoned application of techniques used in the capital budgeting process (6 marks). Using results from your quantatative analysis of the data, your recommendations are sound and demonstrate application of techniques used in the capital budgeting process (4.5 marks). You have made a cursory attempt to recommendation further analysis (1.5-3 marks). Very weak or no recommendations made (0-1 mark).

Memo format and professionalism of communication (3 marks) Memo contains all of the required elements and formatting. Rules of grammar & punctuation are followed, no spelling errors or jargon, easily understood by a lay person (3 marks). Memo contains most of the required elements and formatting. Rules of grammar & punctuation are followed, few spelling errors or jargon, easily understood by a lay person (2-2.5 marks). Memo contains some of the required elements and formatting. Rules of grammar & punctuation are generally followed, several spelling errors or jargon, the key points of the memo are not clearly stated (1.5 mark). Memo contains some of the required elements and formatting. Rules of grammar & punctuation are generally followed, several spelling errors or jargon, the key points of the memo are not clearly stated (0.5-1 marks). Memo contains none or very few of the required elements and formatting and contains numerous grammatical, punctuation & spelling errors. Lots of jargon & unexplained acronyms (0 marks).

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.

Marking Criteria

Your boss has 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 30% weighting in your overall mark for this unit. It will be marked out of 30. Marks will be allocated as per rubric on following page based on:

- Accurate analysis of base case figures (18 marks)

- Sound recommendations on the alternatives founded on base case analyses (1.5 mark) - Insightful recommendations for further considerations prior to final decision (7.5 marks) - Memo format and professionalism of communication (3 marks).

Marking Rubric for ACC00152 S1 2018 Assignment

MARKING CRITERIA Excellent Very Good Good Fair Poor

Accurate analysis of base case figures for Option A (13.5 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option A (13.5 marks) You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option A (10-13 marks) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option A (7-9.5 marks) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option A (3.5-6.5 marks) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option A (0-3 marks)

Accurate analysis of base case figures for Option B (3 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option B (3 marks) You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option B (2-2.5 marks) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option B (1-1.5 mark) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option B (0.5 mark) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option B (0 mark)

Accurate analysis of base case figures for Option C (1.5 marks) You have selected and used all the correct variables for the base case analysis and calculated all the incremental free cash flows and the correct NPV for Option C (1.5 marks). You have selected and used all the correct variables for the base case analysis and calculated most of the incremental free cash flows. You have used the correct method to calculate the NPV for Option C (1 mark) You have selected and used most of the correct variables for the base case analysis and calculated some of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option C (0.75 mark) You have selected and used some of the correct variables for the base case analysis and calculated a few of the incremental free cash flows. You have used the correct method to calculate the

NPV for Option C (0.5 mark) None or very few of the correct variables have been used for the base case analysis and calculated none or hardly any of the incremental free cash flows and the correct NPV for Option C (0 mark)

Sound recommendations on the alternatives founded on base case analyses (1.5 mark) You have made a recommendation for A, B or C applying the NPV investment decision rule (1.5 mark). You have made a recommendation for A, B or C applying the NPV investment decision rule (1 mark). You have made an attempt to make a recommendation for A, B or C applying the NPV investment decision rule (0.75 mark). You have made an attempt to make a recommendation for A, B or C applying the NPV investment decision rule (0.5 mark). No recommendations made (0 mark).

Insightful recommendations for further considerations prior to final decision (7.5 marks) Using results from your quantatative analysis of the data, your recommendations are insightful and demonstrate a critical application of techniques used in the capital budgeting process (7.5 marks). Using results from your quantatative analysis of the data, your

recommendations are considered and demonstrate a reasoned application of techniques used in the capital budgeting process (6 marks). Using results from your quantatative analysis of the data, your recommendations are sound and demonstrate application of techniques used in the capital budgeting process (4.5 marks). You have made a cursory attempt to recommendation further analysis (1.5-3 marks). Very weak or no recommendations made (0-1 mark).

Memo format and professionalism of communication (3 marks) Memo contains all of the required elements and formatting. Rules of grammar & punctuation are followed, no spelling errors or jargon, easily understood by a lay person (3 marks). Memo contains most of the required elements and formatting. Rules of grammar & punctuation are followed, few spelling errors or jargon, easily understood by a lay person (2-2.5 marks). Memo contains some of the required elements and formatting. Rules of grammar & punctuation are generally followed, several spelling errors or jargon, the key points of the memo are not clearly stated (1.5 mark). Memo contains some of the required elements and formatting. Rules of grammar & punctuation are generally followed, several spelling errors or jargon, the key points of the memo are not clearly stated (0.5-1 marks). Memo contains none or very few of the required elements and formatting and contains numerous grammatical, punctuation & spelling errors. Lots of jargon & unexplained acronyms (0 marks).

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