PLZ PLZ HELP QUESTION 1 Rectangle Space is a Cwmbran based company which manufactures solar powered bricks that can be u

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PLZ PLZ HELP
QUESTION 1
Rectangle Space is a Cwmbran based company which manufactures
solar powered bricks that can be used pave a drive or garden path
with solar lights. Over the past three years, Rectangle Space
has witnessed a steady fall in its sales due to numerous complaints
of faulty products. Rectangle Space’s director Mr. Bright
claims the company has undergone a thorough quality control audit
and all faults have been rectified. Although the quality of the
products has improved, Mr. Bright is worried the negative publicity
will continue to depress sales in the UK. To improve the company’s
financial health, Mr. Bright has decided to target the Icelandic
market by setting up a joint venture with an Iceland based company
known as Aurora Limited.
Aurora has expressed an interest in using Rectangle Space’s
technical expertise and patent rights to open a domestic production
facility. Aurora believes once production commences, it will be
able to sell the brick to national and international customers.
Due to the lower labour costs in Iceland, Aurora anticipates
there will be a saving of 45% to manufacture in Iceland as opposed
to Cwmbran. If the agreement is successful Rectangle Space
will be required to:
The joint venture agreement will be for a period of 4 years.
Thereafter, Aurora will buy Rectangle Space's share in the joint
venture for 10 million ISK. The joint venture agreement will
entitle Rectangle Space to a 45% share of the profits or losses.A
standard brick is expected to sell in Iceland for a price of 6000
ISK per unit in year 1. Prices will then increase by the expected
rate of inflation in Iceland. It is expected 10,000 units will be
sold in Iceland in the first year, this will rise by 10% each year
over the next three years.
The joint venture is also expected to sell 5,000 units of the
brick each year to the USA at a constant price of $45 per unit.
Rectangle Space currently exports similar brick to the USA,
providing a pre-tax contribution of £150,000 per year. Because of
the cheaper price of brick manufactured in Iceland it is expected
that 50% of these exports will be lost.
Provision of initial technical assistance will cost Rectangle
Space £120,000 and ongoing aid would cost £30,000 per year in
salaries, at current prices. Neither would be tax allowable
expenses in Iceland, although the salaries would be tax allowable
in the UK. There are no cash costs associated with using the
patents, however, this will mean that the patent cannot be sold to
another company which is willing to pay a constant sum of £45,000
per year to use the patent. In year 1, direct costs in Iceland
will be 1000 ISK per unit, and fixed costs 3 million ISK per annum;
both these costs are expected to increase by the inflation rate in
Iceland.
Tax allowable depreciation in Iceland is 50% per year on a
reducing balance basis. The tax rate in Iceland is 20% and in the
UK 30%. A bilateral tax agreement exists between Iceland and the
UK. Tax is payable one year in arrears.
Expected inflation rates (%):
UK
Iceland
USA
Years 1 – 2
3
2
5
Years 3 – 5
4
3
5
Spot exchange rates:
Icelandic króna ISK 132.00/£
Icelandic króna ISK 178.05/US$
Rectangle Space's cost of capital is 10%. Due to the risk
associated with manufacturing overseas, Mr. Bright is proposing to
use 12% as the cost of capital for the joint venture.
Required:
You are a management accountant of Rectangle Space. Prior
to finalising the joint venture agreement, Mr Bright has approached
you for advice.
Write a short memo addressed to Mr Bright evaluating whether
Rectangle Space should participate in the joint venture. Within
your memo you should include:
i) The Net Present Value of the project in UK
£s using a discount rate of 12%.
iii) Using Rectangle Space’s case study,
evaluate the implications of using an organic growth strategy.
Summarise the potential negative implications for Rectangle
Space for entering into a joint venture agreement with
Aurora.
State clearly any assumptions that you make.