Assignment: Memo to Management

Ingenious Pty Ltd (a fictitious company) designs information and communication technology hardware. It has just completed its development of a new type of earpiece for connection to mobile devices. To achieve this, the company has incurred research and development expenditure of $1 million over the past year. The company directors are excited about the new product and are carefully considering three alternatives for getting the product to market

Alternative 1

Ingenious 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 Ingenious manufacturing and selling the earpiece itself. In order to estimate production and marketing cash flows for the product, Ingenious paid an external consultant $100,000 for a feasibility and market research report. The report recommends producing and selling the product for five years only as technological change will likely render the earpiece obsolete after that time. Sales of the earpiece are estimated as follows:

In the first year, it is estimated that earpieces will be sold for $30 each. However, the price will drop in the following three years to $22 each and fall again to $20 in the final year of the project, reflecting the effects of anticipated competition. Variable production costs are estimated to be $14 per earpiece for the entire life of the project. Fixed production costs (excluding depreciation) are
predicted to be $800,000 per year and marketing costs will be $2 million per year.

To enable production, the company will use factory space it currently rents to another business for $100,000 per year. Additionally, equipment costing $9 million will have to be purchased. Ingenious 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
$1 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.

Alternative 2

A multinational business, Release Ltd, has made an offer in which it would manufacture and market the product under license for 5 years. For each unit sold, Release will pay a $4 royalty to Ingenious as part of its licensing agreement. Due to its international reach and strong distribution networks, the external consultant estimates that Release can sell 10% more earpieces each year than Ingenious.

Alternative 3

As an alternative to a licensing arrangement, Release Ltd has offered to buy the patent rights to the earpiece design from Ingenious for $20 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 Ingenious' 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), Ingenious is expected to have other sources of taxable income.

Your Task

Your boss, Ingenious' CFO Tom Wheeler, has asked you to analyse the three alternatives and draft a memo to the Board of Directors providing recommendations on the alternatives, along with supporting analysis.

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

1. Analyse base case figures for the earpiece alternatives 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 earpieces (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.