Financial Analysis of Alternatives - Recommendation Memo

This memo provides a financial analysis of three alternatives and recommends the most superior option based on NPV. It also discusses key findings, recommendations, and input assumptions.

BUSINESS FINANCE
MEMORANDUM
STUDENT ID:
[Pick the date]

MEMORANDUM
DATE: May 19, 2019
TO: BOARD of DIRECTORS (MNT)
FROM: STUDENT NAME
SUBJECT: Recommendation on the alternatives available
Dear Sirs/Madams
The objective of this memo is to share the findings with regards to the financial analysis of the
alternatives available and recommending the most superior option.
Method
In order to carry out the evaluation, incremental cashflows in each of the alternatives were
identified over the project duration. These incremental cashflows were then used to determine
the Net Present Value (NPV) for the three mutually exclusive options. The decision rule is that
the option that yields the maximum NPV should be favoured.
Key Findings
The key findings of the financial analysis of the three alternatives lead to the following findings.
 NPV of Option A is $ 10.46 million.
 NPV of Option B is $ 7.24 million.
 NPV of Option C is $ 6.07 million
Recommendations
In accordance with the decision rule, Option A is the most superior option as the related NPV
with this alternative is the highest. This would ensure that the wealth of the shareholders are
maximized. It is imperative to note that all the three alternatives are financially feasible since
NPV exceeds zero but since the options are mutually exclusive, only one of the three alternatives
can be accepted. However, the final decision to be taken by board must also consider the
qualitative aspects that have not been considered.
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Input Assumptions
The various input related assumptions that have been made for the current analysis are outlined
below.
 It has been assumed where not specified that the respective cashflow would occur on the
last day of the concerned financial year.
 Any capital losses made on the sale of equipment cannot be adjusted against the
assessable income and thereby the same has been discarded.
 It has been assumed that the factory can be rented after the project is completed. This is
essential as the opportunity cost built in the model considers loss of rental revenues for
only the five year period when sales would be derived from the new product.
 The cost of capital remains the same for the firm and also across the three options despite
the differences in underlying risk level.
Estimated Cash Flows
The estimated incremental cash flows from Option A are as highlighted below.
The estimated incremental cash flows from Option B are as highlighted below.
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The estimated incremental cash flows from Option C are as highlighted below.
Supplementary Analysis Detail
The supplementary analysis for each of the three options is carried out below.
Option A:
Besides, other cashflows that are captured, a pivotal aspect is the opportunity cost involved as if
the company does decide to move ahead with the project that the existing premises would be
used for product manufacturing and thereby the rental income of the company would be
adversely impacted. Since it is a revenue item which would be taxed, thereby similar treatment
has been extended in the analysis as well. The computation of annual depreciation is shown
below.
Annual depreciation = (11/100)*($80 million - $ 15 million) = $ 7.26 million
Depreciation is not an actual cash flow but still it has been considered for the given project
which is on account of the lower tax outflow that would be caused and hence actual cash flow
benefit would arise for the firm. Hence, it is subtracted at the beginning when tax has to be
computed but is added later when tax benefit has been derived. The requisite computation with
regards to working capital related cash flows is shown below.
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Option B:
The estimated sales units have been estimated by giving a 2% hike for the sale estimates of
Option A. The post-tax royalty related cash flows have been determined and the NPV has been
determined considering the 15% cost of capital.
Option C:
The pivotal aspect with regards to cashflows is that while the patent payments are received at the
beginning of the year, they would be taxed at the end of the year. Owing to this there is a lag
effect which has been captured while estimating the incremental cashflows. The NPV has been
determined considering the 15% cost of capital.
Discussion
The NPV computed is $10.46 million, $ 7.26 million and $ 6.07 million for Option A, Option B
and Option C respectively. The above amounts indicate the extent of contribution to the
shareholders’ wealth. Considering that Option A has the highest NPV, it makes sense for MNT
to pursue this option. However, it would be worthwhile to perform uncertainty analysis for
Option A using tools such as scenario analysis and sensitivity analysis. This would allow for
better decision making as in Option A, the risk with regards to sales and underlying price would
be borne by the company. This is not the case for Option B and Option C where the underlying
risk is much lower. For instance in option C, there is outright sale of patent which implies that
the risk related to product sale, realization and any competition is borne by the patent buyer.
Yours Sincerely
STUDENT NAME
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