ACC00716 Finance: Recommendation for DuoLever's New Plastic Tech

This report presents a financial analysis to aid DuoLever Limited in deciding how to proceed with its new plastic packaging technology. The analysis compares two main options: establishing an in-house manufacturing facility versus licensing the technology to an external partner. The report evaluates the financial implications of each option, focusing on Net Present Value (NPV) calculations considering factors like initial investment, operational costs, sales projections, and cost of capital. Scenario analysis is performed to account for uncertainties, evaluating base, optimistic, and pessimistic cases to determine a weighted average NPV for each approach. The report recommends the licensing option based on its superior NPV and includes a discussion of qualitative factors such as potential risks associated with technology transfer and competition. References to relevant financial literature are provided to support the analysis and recommendations.

FINANCE
STUDENT ID:
[Pick the date]

MEMORANDUM
Date: 18th May, 2019
From: STUDENT NAME
To: DuoLever CEO
Subject: Recommendation for mode of proceeding with new plastic technology based on
financial analysis
Dear Sir
The company is poised to introduce the new plastic packaging which is expected to bring
significant gains for the company. In order to move forward, the company needs to decide if it
should set up own manufacturing facility or license the technology to an outside partner. This
memo addresses this issue using financial analysis as the underlying parameter. Considering the
results obtained, recommendation is offered in relation to the superior option for the company.
Financial Analysis – Setting a Manufacturing Unit
The underlying financial analysis is based on the incremental cash flows which the project is
expected to deliver which would be then used for calculation of NPV for the project. In this
regards, a noticeable observation is that $ 50 million investment for the plastic technology would
be sunk cost and thereby irrelevant for the current analysis. This is because this cost is historical
cost and is non-recoverable irrespective of the decision by the management.
The key benefits considered are summarized below.
 Higher sales that would arise owing to the customers acting in an environment
responsible manner
 Lower cost of manufacturing owing to energy efficiency gains. However, it is noteworthy
that supplier margin gains would not be realized as the same would be adjusted against
the supplier for recycled plastic.
The key costs considered are summarized below.

 Set up of the manufacturing facility would involve one time investment of $ 20 million at
the present. Annual depreciation expense = (20/5) = $4 million. This is because the book
value of equipment would be reduced to zero over 5 years.
 Annual cost of $ 2 million on account of selling, general & administrative costs related to
the given project.
With regards to the relevant cost of capital, it is noteworthy that the funding of the project is via
$ 20 million debt with $ 1.4 million annual interest payment. This would imply an interest rate of
7% p.a. which has been considered as required return for the project even though WACC is 8%.
The relevant NPV computation is illustrated below (Brealey, Myers and Allen,2014).
The above NPV exceeds zero which would imply that the project would have positive impact on
the value of the company and may be accepted.
Financial Analysis – Licensing the patented technology
Under this arrangement, the company would execute an arrangement with Clean World (an
external supplier) whereby patented technology is licensed and the external supplier would
exclusively provide the company with new plastic sachets over the given 5 year period. The
implications of this agreement in cost benefit terms for the company are indicated as follows.
 No need of any upfront investment in setting the manufacturing facility.

 Since administration costs would not be required, hence incremental SGA (Selling,
General & Administrative) expenses are lowered by $ 1 million on an annual basis.
 The company would not be able to lower the variable cost as the gains from higher
energy efficiency would be derived by the external supplier. However, the benefit from
higher sales from environment sensitive consumers would be still derived by the
company.
The cost of capital is considered as 8% p.a. which is WACC for the company. The calculation of
NPV has been carried out in the attached spreadsheet and relevant illustration pasted below.
The above NPV exceeds zero which would imply that the project would have positive impact on
the value of the company and may be accepted.
Scenario Analysis (Manufacturing)
The above computation of NPV is based on future projections and estimates which are subject to
change on account of a host of factors. As a result, a weighted average NPV is more appropriate
for decision making which would be derived on NPV for the given proposal using the following
three scenarios (Damodaran,2015).
 Base Case ( p=0.5 or 50%)
 Optimistic Case ( p=0.25 or 25%)
 Pessimistic Case ( p =0.25 or 25%)
The scenario definition and weighted average NPV is carried below.
Optimistic Case – This highlights the scenario where the economic growth is more robust than
earlier estimated. The changes are summarized below.

 Annual future sale forecasts to increase from 3% p.a. to 4% p.a.
 Owing to overwhelming response from consumers, incremental sales on the forecast
revised from 2% to 3%.
 Finally, the decrease in variable cost enhanced from 15% to 16% on account of
economies of scale.
The estimated NPV calculation is indicated as follows.
NPV estimate under this scenario = $ 9.65 million
Pessimistic Case – This highlights the scenario where the economic growth is lackluster. The
changes are summarized below.
 Annual future sale forecasts to decrease from 3% p.a. to 2% p.a.
 Owing to lukewarm response from consumers, incremental sales on the forecast revised
from 2% to 1%.
 Finally, the decrease in variable cost enhanced from 15% to 14% on account of
diseconomies of scale.
The estimated NPV calculation is indicated as follows.

NPV estimate under this scenario = -$ 5.58 million
Weighted average NPV = 0.5*($1.94 million) + 0.25*(9.65-5.53) = $ 2 million
Scenario Analysis (Licensing)
The scenario definition for this case is the same as for the manufacturing option. The relevant
NPV under different scenarios along with their probabilities is summarised below.
 Base Scenario (NPV = $9.90 million, p =0.5)
 Optimistic Scenario (NPV = $16.71million , p=0.25)
 Pessimistic Scenario (NPV = $3.34 million, p =0.25)
Weighted average NPV = 0.5*($9.9 million) + 0.25*(16.71+3.34) = $ 9.96 million
Recommendation
The project which has the higher NPV should be preferred as it would lead to higher increase in
the wealth of shareholders. In the given instance, both in base case and scenario adjusted NPV, a
superior value is obtained for licensing option which clearly indicates that it is superior than
putting up own manufacturing (Petty et. al.,2016). However, before taking a final call other
qualitative parameters such as potential issues with patented technology transfer, litigation,
competition from Clean World must be considered by the requisite decision authority (Brigham
and Houston, 2014).

Yours Sincerely
STUDENT NAME

References
Brealey, R.A., Myers, S.C. and Allen, F. (2014) Principles of corporate finance. 2nd ed. New
York: McGraw-Hill Inc, pp. 167
Brigham, E. F. and Houston, J. F., (2014). .Fundamentals of Financial Management (14th ed.).
Boston: Cengage Learning, pp. 198
Damodaran, A. (2015) Applied corporate finance: A user’s manual. 3rd ed. New York: Wiley,
John & Sons, pp. 134
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia, pp. 211

Appendix
Manufacturing (NPV- Base Case)
Licensing (NPV- Base case)