Ang Thong Pty Ltd has spent $5 million to bring an anti-snoring device (No-Snore) up to a marketable product. Prototypes have proven that the product is fully functional and the company must consider the way forward in bringing the product to market. They have four alternatives:
1. Manufacture and market No-Snore by forming a new area of the company that extends its traditional role as a research and development business to manufacturing and marketing – utilisation of current surplus space.
2. Similar to option 1, however, the manufacturing space to be commercially rented.
3. Contract another specialist manufacturing and marketing company to produce and sell No-Snore.
4. Sell the patient rights for No-Snore to a multinational company to exclusively manufacture and market the No-Snore product.
Option 1 – Manufacture and Market
Ang Thong has not, as yet, manufactured and marketed the products it has developed, however this option is now available for the business to gear up in some space, owned by the company but currently leased to another unassociated business for $100,000 per annum. The plant and equipment to undertake the manufacturing will cost $9 million with an initial working capital of $3 million. Depreciation is by the prime method over 5 years with a residual value of 50%.
Marketing research (costing $50,000) indicates that the new product has an expected life of 5 years. Sales, selling price and costs during this period are expected to be as per table 1:
Table 1: Sales Budget for No-Snore
2019 2020 2021 2022 2023
Units ('000) 800 1400 1800 1200 500
Selling Price $30 $22 $22 $22 $20
Material Cost/unit $9.80 $9.80 $9.80 $9.80 $9.80
Fixed Costs (w/o rent) $1,500,000 per annum in 2018 (not including depreciation)
Marketing Costs $2,000,000 per annum in 2018
Production wages are expected to be 30% of the materials cost.
Fixed costs are expected to increase by 3.5% per annum.
Marketing Costs are expected to increase by 2.5% per annum.
Option 2 – Manufacture and Market
The same budget applies to this option, however, the business would rent a factory and distribution centre closer to a transport hub for $75,000 per annum, increasing by 4% per annum. This location will reduce marketing costs by $10,000 per annum. The premises would have to be altered to install the production equipment at a cost of $100,000.
Option 3 – Specialist Company Contract
Ang Thong has the option of contracting another, unassociated company to manufacture and market No-Snore under license. This company is experienced in marketing and manufacturing similar products. This company would pay a royalty of $5.50 per unit. This company has estimated that the sales of No-Snore will be 10% higher if their existing marketing channels are deployed to distribute the product.
Option 4 – Patent Rights Contract
Ang Thong has been approached by a large pharmaceutical business (BigPhama) who have offered to purchase the patent rights to No-Snore. They have offered $21.2 million payable in two equal instalments – at commencement of the first year and again at the commencement of the third year.
Required:
Present an internal investment advice report in which you:
1. Evaluate the four options using appropriate capital investment methodologies.
2. Explain your use of an appropriate methodology including what assumptions you have made (if any). Include in your explanation methodologies that you may have considered but not used and why they were not used.
3. Identify and discuss any other factors which Ang Thong should consider before making a decision.
4. Clearly state what you consider to be the most suitable option and why.
5. Show your working out at each stage (such as for each year).
6. Submit your report as well as a spreadsheet for your calculations.
Notes:
• Your report should be persuasive and will be marked on its professional communication of the solution as well as the accuracy of the solution itself;
• Ignore taxation in your calculations;
• Ang Thong’s cost of funds borrowed from a consortium of banks is 7.5% per annum.
• Ang Thong’s internal policy is that the use of money carries a risk loading of 4.5% per annum.
• The inflation rate is 3.5% per annum expected to remain the same for the next 5 years.
• Alterntive investment rate of return is 4%.
Hints:
• The profitability of each option is an important starting position.
• In this case working capital is used for the life of the project and is returned at the same amount at the end of the project.
• Some costs are sunk (have been expended) and in that regard they will not be relevant for comparisons between options under some methodologies.
• You need to consider foregone costs.
• Make this explanation relevant to the Ang thong business, not just motherhood statements.