Finance for Business
A2 Case Study
You are working in the finance department of SunLife Ltd (SUN). The Company has spent $2 million in research and development over the past 12 months developing pioneering solar cell technology which will be incorporated into the retail solar energy market. SUN now need to choose between the following three options for bringing the product to market. These options are:
Option 1: Manufacturing the product “in-house” and selling directly to the market
Option 2: Licensing another company to manufacture and sell the product in return for a royalty
Option 3: Sell the patent rights outright to another company.
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Your Task
Your manager, SUN’s CFO, Ms. Donna Shine, 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. Shine has outlined the following three (3) areas you need to cover in your memo:
a) Analyse base-case figures for the three options and use 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
Five months ago, SUN paid an external consultant $1.2 million for a production plan and sales forecast. 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:
The consultant’s report also provides the following cost forecasts:
– Variable production costs: $600 per unit for the entire life of the project.
– Fixed production costs (excluding depreciation): $700,000 per year, and
– Marketing costs: will be $350,000 per year.
Production will take place in factory space the company owns and currently rents to another business for $650,000 per year. Equipment costing $50 million will have to be purchased. This equipment will be depreciated for tax purposes using the prime cost method at a rate of 15% per annum. At the end of the project, the company expects to be able to sell the equipment for $4.5 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. (Refer to the spreadsheet example provided in the Assessment Submission and Details section of the learning site).
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Option 2: Licensing another company to manufacture and sell the product in return for a royalty
High Power Solar Ltd (HPS), a multinational corporation, has expressed an interest in manufacturing and marketing the product under license for 5 years. For each unit sold, HPS will pay $250 royalty fees per unit to SUN as part of its licensing agreement. Due to HPS’s international reach and strong distribution networks, it is estimated that they can sell 5% more units each year than SUN.
Option 3: Sell the patent rights outright to the company mentioned in Option 2
As an alternative to a licensing arrangement, HPS has offered to buy the patent rights to the product design from SUN for $44 million. This amount would be paid in 4 (four) equal annual instalments, with the first payable immediately.
General Information Relevant to the Analysis
SUN’s weighted average cost of capital (WACC) is 14% and the company is subject to a 30% tax rate. Assume that royalties and patent rights 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), SUN is expected to have other sources of taxable income.
Format/Structure
Your manager at SUN 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.
