Questions:
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).
Answer:
Memo
To
Savanah Harley
Chief financial officer
Space Sky Flight Ltd (SSF)
Subject: Evaluation of three investment options by considering Net present value investment appraisal tool to recommend suitable option.
Net present value
For the present analysis NPV is selected because this tool shows computation that makes comparison of the invested amount to the present value of receipts of future cash flows from the investment. The amount that is invested is contrasted with the amounts of future cash after the deduction of discount by a given rate. It is an evaluation of profit computed by deducting the present value of cash outflows inclusive of initial costs from the cash inflows of prevents value over the time. Decision rule:
NPV must be positive and comparatively higher than available options
Decision table[1]
|
Investment option
|
Net present value of project
|
Option to be selected
|
|
Option A
|
$59.89 million
|
Option C should be selected as it has highest NPV.
|
|
Option B
|
$72.43 million
|
|
Option C
|
$79.7 million
|
Option C is also beneficial because merely patent rights are sold to other Aero Jett Ltd in future if company believes that they can produced at lower cost and to earn higher benefits then they can relinquish the rights.
From
Finance department
Space Sky Flight Ltd (SSF) Date 11-May-2018
Supporting analysis
NPV of option 1
|
|
Statement showing Cash Inflows if product is manufactured in house and sold directly to the market
|
|
|
|
|
|
|
|
(In$)
|
|
|
Particulars
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
|
|
|
|
|
|
|
|
|
Sales Price/ Unit of the Product
|
110000
|
70000
|
70000
|
70000
|
50000.00
|
|
|
(-)Variable Cost/ Unit of the Product
|
35000
|
35000
|
35000
|
35000
|
35000.00
|
|
|
|
|
|
|
|
|
|
A
|
Contribution/ Unit of the Product
|
75000
|
35000
|
35000
|
35000
|
15000.00
|
|
|
Total Production during the years (Units)
|
4000
|
3500
|
5500
|
3000
|
1500.00
|
|
|
|
|
|
|
|
|
|
|
Total Contribution
|
300000000
|
122500000
|
192500000
|
105000000
|
22500000
|
|
B
|
Total Contribution (in Millions)
|
300.00
|
122.50
|
192.50
|
105.00
|
22.50
|
|
|
|
|
|
|
|
|
|
|
Fixed Production Cost
|
11.50
|
11.50
|
11.50
|
11.50
|
11.50
|
|
|
Fixed Marketing Cost
|
9.50
|
9.50
|
9.50
|
9.50
|
9.50
|
|
|
Depreciation (Working Note 1)
|
44.00
|
44.00
|
44.00
|
44.00
|
44.00
|
|
|
Opportunity Cost of Rent foregone
|
7.50
|
7.50
|
7.50
|
7.50
|
7.50
|
|
|
|
|
|
|
|
|
|
C
|
Cash Flows before tax
|
227.50
|
50.00
|
120.00
|
32.50
|
-50.00
|
|
D
|
Tax @ 30%
|
68.25
|
15.00
|
36.00
|
9.75
|
0.00
|
|
E
|
Cash Flows After Tax
|
159.25
|
35.00
|
84.00
|
22.75
|
-50.00
|
|
|
Add: Depreciation For the Year
|
44.00
|
44.00
|
44.00
|
44.00
|
44.00
|
|
|
|
|
|
|
|
|
|
F
|
Net Cash Inflows for the Years
|
203.25
|
79.00
|
128.00
|
66.75
|
-6.00
|
|
G
|
Discounting Factor @ 16%
|
0.86
|
0.74
|
0.64
|
0.55
|
0.48
|
|
|
|
|
|
|
|
|
|
H
|
Present Value of Cash Flows
|
175.22
|
58.71
|
82.00
|
36.87
|
-2.86
|
|
Statement showing Total Cash Inflows during the entire life of the Project
|
|
|
Particulars
|
Amount (In Million)
|
|
|
|
|
|
A
|
Total Present Value of Cash Inflows
|
349.94
|
|
B
|
Salvage Value of Equipment at the end of the Project
|
55.00
|
|
C
|
Investment in Net working Capital
|
79.70
|
|
D
|
Discounting Factor at the end of 5th Year
|
0.48
|
|
E
|
Present Value of Salvage Value and Investment in Net Working Capital at the end of the Project
|
64.66
|
|
|
|
|
|
F
|
Total Present Value of Cash Inflows
|
414.59
|
|
Statement Showing Initial Outlay of the Project if product is manufactured in house and sold directly into the market
|
|
|
Particulars
|
Amount (In Million $)
|
|
A
|
Cost of the Equipment
|
275
|
|
B
|
Investment in Working Capital (Working Note 2)
|
79.7
|
|
|
|
|
|
C
|
Total Initial Outlay of the Project
|
354.7
|
|
Statement showing NPV of the Project
|
|
|
|
Amount (In Million$ )
|
|
A
|
Present Value of Cash Inflows over the Period of Project
|
414.59
|
|
|
|
|
|
B
|
Initial Outlay of the Project
|
354.7
|
|
C
|
Net Present Value
|
59.89
|
Notes
- Cost of plan and demand analysis is sunk cost in option A.
NPV of option 2
|
Statement showing Cash Inflows if product is manufactured by Aero Jett Inc.
|
|
|
|
|
|
|
|
(In$)
|
|
|
Particulars
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
A
|
Sales Volume (In Units)
|
4200
|
3675
|
5775
|
3150
|
1575
|
|
B
|
Royalty/ Product
|
8250
|
8250
|
8250
|
8250
|
8250
|
|
C
|
Total Royalty
|
34650000
|
30318750
|
47643750
|
25987500
|
12993750
|
|
D
|
Total Royalty (In Millions)
|
34.65
|
30.32
|
47.64
|
25.99
|
12.99
|
|
E
|
Tax @ 30%
|
10.40
|
9.10
|
14.29
|
7.80
|
3.90
|
|
F
|
Cash Flows after tax
|
24.26
|
21.22
|
33.35
|
18.19
|
9.10
|
|
G
|
Discounting Factor @ 16%
|
0.86
|
0.74
|
0.64
|
0.55
|
0.48
|
|
H
|
|
|
|
|
|
|
|
E
|
Present Value of Royalty
|
20.91
|
15.77
|
21.37
|
10.05
|
4.33
|
|
F
|
Total Net Present Value of Royalty
|
72.43
|
NPV of option 3
|
Statement showing Cash Inflows if Patent Rights are sold to Aero Jett Inc.
|
|
|
|
|
|
|
|
|
Particulars
|
Year 0
|
Year 1
|
Year 2
|
|
A
|
Patent Fees
|
40
|
40
|
40
|
|
B
|
Tax @ 30%
|
12
|
12
|
12
|
|
C
|
Patent Fees after tax
|
28
|
28
|
28
|
|
D
|
Discounting Factor @16%
|
1
|
0.86
|
0.74
|
|
E
|
Present Value of Patent Fees
|
28
|
24.08
|
20.72
|
|
F
|
Total Net Present Value If Patent Rights are sold
|
72.8
|
Working note
|
Working Note 1
|
|
|
Computation of Depreciation
|
|
|
|
(In Millions)
|
|
Particulars
|
Amount
|
|
Cost of the Equipment
|
275
|
|
Salvage Value at the end of the Project
|
55
|
|
Net Cost of the Equipment
|
220
|
|
Rate of Depreciation
|
20%
|
|
Depreciation/ Annum
|
44
|
|
Working Note 2
|
|
Computation of Net Working Capital
|
|
|
|
|
|
|
Particulars
|
Sales
|
Amount
|
Amount In Million
|
|
Account Receivable (25% of Sales)
|
440000000
|
110000000
|
110
|
|
Less: Account Payable (20% of Production Overhead and Variable Cost)
|
151500000
|
30300000
|
30.3
|
|
|
|
|
|
|
Net Investment in Working Capital
|
|
|
79.7
|
