Ang Thong Case Study on Business Investments
Question
Task: 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:
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.
Similar to option 1, however, the manufacturing space to be commercially rented.
Contract another specialist manufacturing and marketing company to produce and sell No-Snore.
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.
Answer
Executive Summary
This Ang Thong case study report provides an analysis of the four investment options available in the hands of Ang Thong Pty Ltd. The report not only discusses the quantitative aspects of investment analysis but also the qualitative aspects. In order to deal with the quantitative aspect, net present value technique of capital budgeting has been applied. The rest of the techniques of capital budgeting such as internal rate of return, discounted payback period, and profitability index have been considered redundant in the current case. The results of net present value show that the fourth option (sale of patent rights) is the most advantageous for the company. This option yield an NPV of $3,920,845.21 which is the highest among all four alternatives. The lowest NPV is of option-3 (contract with third party on royalty basis) of $25,849,478.76.
Introduction
Capital investment decision is one of the crucial aspects of the business. The business managers are expected to be acquainted with the knowledge of capital budgeting concepts and methodologies to perform this task. There are various tools and techniques of capital budgeting that are applied in assessing a capital investment decision. The most prominent ones include net present value, internal rate of return, discounted payback period, and profitability index (Bierman and Smidt, 2012). Apart from these tools, accounting rate of return could also be applied in evaluating the financial viability of the project but it is considered as an orthodox technique because it ignores the effect of time value of money. In the current Ang Thong case study, an evaluation of various alternatives for Ang Thong Pty Ltd has been made by applying the capital budgeting techniques. This Ang Thong case study not only presents the financial evaluation of the alternatives but it also discusses the capital budgeting techniques in detail. Further, the light has also been put on the other factors (other than financial factors) that are crucial in making an investment choice for Ang Thong Pty Ltd.
Capital Budgeting Methodology Used
There are three most prominently used capital budgeting techniques such as net present value, internal rate of return, and discounted payback period. Apart from these three capital budgeting techniques, the profitability index and accounting rate of return are also used in evaluating a project’s financial viability (Atrill and McLaney, 2006). In the current case of Ang Thong Pty Ltd., there are four alternatives under consideration of the company. The company is planning to bring a new product namely “No-Shore” to the market for which it has four alternative ways. Under the alternative-1, the company can perform manufacturing and marketing activities in house by building a new area within the company. Further, under the alternative-2, the company again would perform manufacturing and marketing activities itself but the factory would be rented this time. Under the alternative-3, the company can contract with another company to perform the manufacturing and marketing activities on its behalf. Further, under fourth option, the company can go for patent right contract. So, the characteristics of each alternative are different. In order to compare them and analyse which one is the best one for the company, the capital budgeting techniques namely net present value has been applied.
The net present value gives insight into the profitability of the company and this is the reason that it is considered as one of the most commonly used capital budgeting technique in assessing the financial viability of the projects. Further, the net present value also incorporates the use of time value of money which makes it perfect for use in the evaluation of the financial viability (Graham, Harvey, and Puri, 2015). The net present value is arrived at after deducting the present value of cash inflows from the present value of cash outflows. Further, the present values of cash flows are computed applying the weighted average cost of capital of the company which is representative of the desired rate of return. Thus, it provides nearly accurate analysis in terms of profitability of the project. The other capital budgeting techniques such as internal rate of return, discounted payback period, and profitability index are not useful in the current case. The profitability index is calculated by dividing the present value of the future cash flows by the initial investments. The profitability index of more than 1 indicates that the project is profitable. This tool of capital budgeting is useful in evaluation of the projects having different life terms. However, there must be inflows and outflows of cash to be able to apply this technique. In the current case, third and fourth options do not have any initial outlay and hence profitability index can not be applied.
The accounting rate of return has not been applied considering it inappropriate in the given situation. The accounting rate of return does not consider the impact of time value of money and hence it is considered as outdated in regard to project evaluation. Further, the internal rate of return method has also been ignored in the current case as it suffers from various limitations. The biggest hurdle in applying the internal rate of return method is that it ignores the mutually exclusive projects and further, in case of multiple cash outflows, the calculation of the IRR becomes difficult. Therefore, the analysis of different alternatives under the current case has been done applying net present value technique (Graham, Harvey, and Puri, 2015).
Evaluation of the Alternatives
Ang Thong Pty Ltd, through years of research, has developed anti-snoring device namely No-Snore. The company spent $5 million on the development of this device and now it is looking at different alternatives to bring this device to the market. The financial evaluation of four different alternatives in this connection is given as below:
Option-1: Manufacture and Market in House
Under this option, the company would undertake the manufacturing and marketing activities itself. The company would be required to set up the manufacturing facilities. An initial investment of $9 million is needed for plant and machinery and $ 3 million are needed for working capital. Further, the company would also use its factory space which it has rented to the outsider party for $100,000 per annum till now. Therefore, this rent of $100,000 would be foregone which becomes an opportunity cost for this alternative. Detailed calculations in regard to financial evaluation of this alternative are attached in the excel sheet. However, the calculation of cash flows and the net present value is presented as below:
|
Operating Cash inflows |
|
|
|
|
|
|
|
2019 |
2020 |
2021 |
2022 |
2023 |
|
Sales |
$24,000,000 |
$30,800,000 |
$39,600,000 |
$26,400,000 |
$10,000,000 |
|
Less: Material Cost |
$7,840,000.00 |
$13,720,000.00 |
$17,640,000.00 |
$11,760,000.00 |
$4,900,000.00 |
|
Less: Production wages |
$2,352,000.00 |
$4,116,000.00 |
$5,292,000.00 |
$3,528,000.00 |
$1,470,000.00 |
|
Less: Fixed cost (W/o rent) [note below] |
0 |
0 |
0 |
0 |
0 |
|
Less: Marketing Costs |
$2,050,000.00 |
2101250 |
2153781.25 |
2207625.781 |
2262816.426 |
|
Less: Depreciation [Note below] |
0 |
0 |
0 |
0 |
0 |
|
Less: Rent opportunity cost |
100000 |
100000 |
100000 |
100000 |
100000 |
|
Operating Cash inflows |
$11,658,000.00 |
$10,762,750.00 |
$14,414,218.75 |
$8,804,374.22 |
$1,267,183.57 |
|
Inflation adjusted-Nominal operating cash inflows |
$12,066,030.00 |
$11,139,446.25 |
$14,918,716.41 |
$9,112,527.32 |
$1,311,535.00 |
It could be noted here that the fixed costs are only rent allocated which is not an out of pocket cost. This implies that the allocated overhead of rent in the form of fixed cost is irrelevant to the decision at hand and hence same has been ignored. Further, the depreciation expense is also no cash cost and tax is to be ignored in the current case, hence this cost also does not have any implication on the decision at hand. The rent of factory space that the company would lose due to adoption of this alternative becomes the opportunity cost and hence same has been considered relevant to the decision at hand.
Further, it is to be noted that the discount rate has been calculated by giving effect to the inflation. The discount rate for the option-1 has been calculated based on the cost of borrowed funds assuming that the company would use only the borrowed funds in this current scenario. In order to align the cash inflows with the nominal discount rate, the same also have been given effect for inflation (Goldmann, 2019).
The calculations in regards to net present value for option-1 are given as below:
|
Net present value |
|
|
|
|
|
|
|
|
Base year |
2019 |
2020 |
2021 |
2022 |
2023 |
|
Initial cash outlay |
|
|
|
|
|
|
|
Plant and machinery |
(9,000,000.00) |
|
|
|
|
|
|
initial working capital |
(3,000,000.00) |
|
|
|
|
|
|
Operating Cash inflows |
|
12,066,030.00 |
11,139,446.25 |
14,918,716.41 |
9,112,527.32 |
1,311,535.00 |
|
initial working capital-returned |
|
|
|
|
|
3,000,000.00 |
|
Residual value |
|
|
|
|
|
4,500,000.00 |
|
Total |
(12,000,000.00) |
12,066,030.00 |
11,139,446.25 |
14,918,716.41 |
9,112,527.32 |
8,811,535.00 |
|
Discount factor@11.26% |
1.00 |
0.90 |
0.81 |
0.73 |
0.65 |
0.59 |
|
|
(12,000,000.00) |
10,844,651.16 |
8,998,414.08 |
10,831,410.52 |
5,946,255.79 |
5,167,821.45 |
|
NPV |
29,788,553.00 |
|
|
|
|
|
The net present value of the option-1 is $29,788,553.00.
Option-2: Manufacture and Market
Under this option, the company rather using its own factory space is considering to take a factory space on rent for $75,000 per annum. This factory would be located near to the market place and thus it will result in savings in the market cost of $10,000 per annum. Further, the company would also not incur the opportunity cost of $100,000 in the form of rent forgone. However, this alternative would require an initial outlay of $100,000 for installation of production equipments. The computations of cash inflows and net present value are shown below:
|
Operating Cash inflows |
|
|
|
|
|
|
|
2019 |
2020 |
2021 |
2022 |
2023 |
|
Sales |
$24,000,000 |
$30,800,000 |
$39,600,000 |
$26,400,000 |
$10,000,000 |
|
Less: Material Cost |
$7,840,000.00 |
$13,720,000.00 |
$17,640,000.00 |
$11,760,000.00 |
$4,900,000.00 |
|
Less: Production wages |
$2,352,000.00 |
$4,116,000.00 |
$5,292,000.00 |
$3,528,000.00 |
$1,470,000.00 |
|
Less: Fixed cost (W/o rent) [note below] |
0 |
0 |
0 |
0 |
0 |
|
Less: Marketing Costs |
$2,050,000.00 |
2101250 |
2153781.25 |
2207625.781 |
2262816.426 |
|
Less: Depreciation [Note below] |
0 |
0 |
0 |
0 |
0 |
|
Less: Rent cash cost |
75000 |
78000 |
81120 |
84364.8 |
87739.392 |
|
Add: Savings in marketing cost |
10000 |
10000 |
10000 |
10000 |
10000 |
|
Operating Cash inflows |
$11,693,000.00 |
$10,794,750.00 |
$14,443,098.75 |
$8,830,009.42 |
$1,289,444.18 |
|
Inflation adjusted-Nominal operating cash inflows |
$12,102,255.00 |
$11,172,566.25 |
$14,948,607.21 |
$9,139,059.75 |
$1,334,574.73 |
|
Net present value |
|
|
|
|
|
|
|
|
Base year |
2019 |
2020 |
2021 |
2022 |
2023 |
|
Initial cash outlay |
|
|
|
|
|
|
|
Plant and machinery |
(9,000,000.00) |
|
|
|
|
|
|
initial working capital |
(3,000,000.00) |
|
|
|
|
|
|
premises altered cost |
(100,000.00) |
|
|
|
|
|
|
Operating Cash inflows |
|
12,102,255.00 |
11,172,566.25 |
14,948,607.21 |
9,139,059.75 |
1,334,574.73 |
|
initial working capital-returned |
|
|
|
|
|
3,000,000.00 |
|
Residual value |
|
|
|
|
|
4,500,000.00 |
|
Total |
(12,100,000.00) |
12,102,255.00 |
11,172,566.25 |
14,948,607.21 |
9,139,059.75 |
8,834,574.73 |
|
Discount factor@11.26% |
1.00 |
0.90 |
0.81 |
0.73 |
0.65 |
0.59 |
|
|
(12,100,000.00) |
10,877,209.30 |
9,025,168.32 |
10,853,112.09 |
5,963,569.16 |
5,181,333.88 |
|
NPV |
29,800,392.75 |
|
|
|
|
|
The net present value of this alternative is $29,800,392.75
Option-3: Specialist Company Contract
Under this option the company would enter into a contract with another company to take care of the manufacturing and marketing operations. The company would simply receive royalty against the contact.
The discount rate for evaluation of this alternative has been calculated based on the utilization of own funds. Hence, alternative investment rate (4%) and risk loading (4.5%) have been used to calculate the discount rate.
The computation of the cash flows and net present value has been shown as below:
|
|
2019 |
2020 |
2021 |
2022 |
2023 |
|
Sale units |
800000 |
1400000 |
1800000 |
1200000 |
500000 |
|
Increase in sale units |
10% |
10% |
10% |
10% |
10% |
|
Sale units |
880000 |
1540000 |
1980000 |
1320000 |
550000 |
|
Royalty payment per unit |
5.5 |
5.5 |
5.5 |
5.5 |
5.5 |
|
Royalty payment |
4840000 |
8470000 |
10890000 |
7260000 |
3025000 |
|
Inflation adjusted-Nominal cash inflows |
$5,009,400 |
$8,766,450 |
$11,271,150 |
$7,514,100 |
$3,130,875 |
|
Net present value |
|
|
|
|
|
|
Net cash flow |
$5,009,400 |
$8,766,450 |
$11,271,150 |
$7,514,100 |
$3,130,875 |
|
Discount factor@12.30% |
0.890491774 |
0.7929756 |
0.706138249 |
0.628810302 |
0.559950401 |
|
NPV |
$4,460,829.49 |
$6,951,580.95 |
$7,958,990.12 |
$4,724,943.49 |
$1,753,134.71 |
|
|
$25,849,478.76 |
|
|
|
|
The net present value under this option is 25,849,478.76
Option-4: Patent Rights Contract
Under this option, the company would simply sale the patent rights to third party. The company would receive payment against patent right sale in two instalments. The discount rate taken under this option is same as taken under the third option. The computations of cash flows and net present value are shown as below:
|
Year |
Installment |
Inflation adjustment |
Discount factor@12.30% |
PV |
|
0 |
2,120,000.00 |
2,120,000.00 |
1.00 |
2,120,000.00 |
|
2 |
2,120,000.00 |
2,270,997.00 |
0.79 |
1,800,845.21 |
|
|
|
|
NPV |
3,920,845.21 |
The net present value under this option is $3,920,845.21
Discussion on Other Factors
The most crucial factor in evaluating an investment alternative is its profitability. A firm would accept the investment alternative if it is expected to be profitable for it. However, apart from the profitability, there are other factors (non financial factors) also that may have significant impact on the investment choice. The non financial factors may be availability of raw material, labor, and necessary infrastructure (Batra and Verma, 2017). If the firm chooses a project for which material and/ or labor are not available in the market than it would be failure though the project is profitable. Further, the firm is also required to consider the impact of introducing a new product on the other product lines. The new product might affect the other product lines adversely and the firm may end up losing its main product’s sale in the longer run. In the current case, Ang Thong Pty Ltd is considering various alternatives for manufacture and marketing of new product namely No-Snore. Thus, if the company decides to manufacture and market the product by in house mechanism, it should evaluate the impact on the existing product lines. Moreover, the firm should also evaluate the impact of the investment choice on its goodwill in the market. The firm may lose its goodwill by picking short term profitable but lower quality products which may hamper the long term profitability also (Graham, Harvey, and Puri, 2015).
Final Decision
The net present value of all four alternatives is presented in the table given below:
|
|
Option-1 |
Option-2 |
Option-3 |
Option-4 |
|
NPV |
29,788,553.00 |
29,800,392.75 |
$25,849,478.76 |
3,920,845.21 |
It could be observed that the NPV of the option-4 is highest and hence it is recommended for the company to opt for option-4. Under the option-4, the company will simply sell the patent rights which also relieve it from building the infrastructure for the in house operations and disruption to the existing manufacturing lines.
Conclusion
In the Ang Thong case study present above, a discussion has been made on the capital budgeting techniques and application of these techniques in the evaluation of capital investment decision. Ang Thong Pty Ltd has four options for capital investment and it had to make choice among those four options. In order to analyse the financial viability of the project, the net present value technique of capital budgeting was considered the most appropriate in this Ang Thong case study. Based on the results of net present value, the fourth option that is to sell the patent rights has been recommended to the company as it has highest net present value of $3,920,845.21.
References
Atrill, P. and McLaney, E.J., 2006. Accounting and Finance for Non-specialists. Pearson Education.
Batra, R. and Verma, S., 2017. Capital budgeting practices in Indian companies. IIMB Management Review, 29(1), pp.29-44.
Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.
Goldmann, K., 2019. Time-declining risk-adjusted social discount rates for transport infrastructure planning. Transportation, 46(1), pp.17-34.
Graham, J.R., Harvey, C.R. and Puri, M., 2015. Capital allocation and delegation of decision-making authority within firms. Journal of Financial Economics, 115(3), pp.449-470.
Graham, J.R., Harvey, C.R. and Puri, M., 2015. Capital allocation and delegation of decision-making authority within firms. Journal of Financial Economics, 115(3), pp.449-470.
