You are working in the finance department of Smartech Ltd (SMT). The Company has spent $3 million in research and develo
Posted: Wed Mar 30, 2022 3:42 pm
You are working in the finance department of Smartech Ltd (SMT).
The Company has spent $3 million in research and development over
the past 12 months developing cutting-edge battery technology which
will be incorporated into the electric vehicle market.
Your Task Your manager, SMT’s CFO, Ms Lucinda Harris, 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 analyses.
Ms Harris has outlined the following three (3) areas you need to
cover in your memo:
a) Analyse base-case figures for the three options and using NPV
as the investment decision rule;
b) Provide recommendations based on the base-case analyses;
c) Provide recommendations on further analyses and discuss
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 1: Manufacturing the product “in-house” and selling
directly to the market Three months ago, SMT paid an external
consultant $2 million 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:
In the first year, it is estimated that the product will be sold
for $44,000 per unit. However, the price will drop in the following
three years to $39,000 per unit and fall again to $36,000 per unit
in the final year of the project, reflecting the effects of
competition and technology in the market. Variable production costs
are estimated to be $28,000 per unit for the entire life of the
project.
Fixed production costs (excluding depreciation) are predicted to
be $5 million per year and marketing costs will be $2.1 million per
year. Production will take place in factory space the company owns
and currently rents to another business for $3.5 million per year.
Equipment costing $93 million will have to be purchased. This
equipment will be depreciated for tax purposes using the prime cost
method at a rate of 10% per annum. At the end of the project, the
company expects to be able to sell the equipment for $43
million
Investment in net working capital will also be required. It is
estimated that accounts receivable will be 35% of sales, while
inventory and accounts payable will each be 30% 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
General Information Relevant to the
Analysis
SMT’s weighted average cost of capital (WACC) is 14% 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), SMT is expected to have other sources of taxable
income.
The Company has spent $3 million in research and development over
the past 12 months developing cutting-edge battery technology which
will be incorporated into the electric vehicle market.
Your Task Your manager, SMT’s CFO, Ms Lucinda Harris, 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 analyses.
Ms Harris has outlined the following three (3) areas you need to
cover in your memo:
a) Analyse base-case figures for the three options and using NPV
as the investment decision rule;
b) Provide recommendations based on the base-case analyses;
c) Provide recommendations on further analyses and discuss
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 1: Manufacturing the product “in-house” and selling
directly to the market Three months ago, SMT paid an external
consultant $2 million 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:
In the first year, it is estimated that the product will be sold
for $44,000 per unit. However, the price will drop in the following
three years to $39,000 per unit and fall again to $36,000 per unit
in the final year of the project, reflecting the effects of
competition and technology in the market. Variable production costs
are estimated to be $28,000 per unit for the entire life of the
project.
Fixed production costs (excluding depreciation) are predicted to
be $5 million per year and marketing costs will be $2.1 million per
year. Production will take place in factory space the company owns
and currently rents to another business for $3.5 million per year.
Equipment costing $93 million will have to be purchased. This
equipment will be depreciated for tax purposes using the prime cost
method at a rate of 10% per annum. At the end of the project, the
company expects to be able to sell the equipment for $43
million
Investment in net working capital will also be required. It is
estimated that accounts receivable will be 35% of sales, while
inventory and accounts payable will each be 30% 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
General Information Relevant to the
Analysis
SMT’s weighted average cost of capital (WACC) is 14% 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), SMT is expected to have other sources of taxable
income.