ACC00716 Finance - Assessment 3: Manufacturing vs Licensing Analysis

This report presents a financial analysis comparing two options for DuoLever Company: manufacturing recycled plastic sachets versus licensing the technology to a contract manufacturer. The analysis focuses on incremental cash flows, Net Present Value (NPV) calculations, and the impact of uncertainty through scenario and sensitivity analyses. Option 1 involves manufacturing, requiring a $20 million debt for plant and machinery. Option 2 involves licensing, avoiding the manufacturing setup and related debt. The report considers factors like sales growth, variable costs, and discount rates. Scenario analysis explores optimistic and pessimistic outcomes, while sensitivity analysis assesses the impact of changes in the discount rate. Based on the analysis, the report recommends the licensing option due to its higher positive NPV and lower risk profile, while also suggesting the consideration of qualitative aspects before a final decision. The report includes references and an appendix for further details.

FINANCE
STUDENT ID:
[Pick the date]

MEMORANDUM
To: CEO (DuoLever Company)
From: STUDENT NAME
Date: 19th May, 2019
Subject: Financial Analysis of manufacturing vs licensing options
Respected Sir
The key objective of this memo is to present a summary of the financial analysis which has been
carried out in wake of the two options that the company is currently contemplating for the
recycled plastic sachet project. In this regards, the focus is on identification of incremental
cashflows associated with each of the two options after which the NPV has been determined
using the respective cost of capital. Further, uncertainty in financial projections has also been
considered so as to outline the impact of adverse movements in critical inputs on the project
feasibility.
NPV Computation
Option 1:
For the given analysis, focus is only on incremental cash flows which would be derived based on
the decision to go ahead with the project or abandon the same. This would imply that sunk costs
such as the $ 50 million investment made by the company to develop the environment friendly
plastic technology would not be considered in the financial analysis. Another key factor is the
funding of project and resultant cost of capital. The project is 100% debt funded with an interest
rate of 7% which becomes the relevant discount rate (Ross et. al.,2015).
Going ahead with the option under consideration would bring about the following incremental
cash inflows for DuoLever company.
 The current sales forecast for the next five year would undergo upward revision to the
extent of 2% as customers would prefer environmental friendly product against the
alternatives which lack this feature.

 The company would reap savings in variable cost associated with packaging to the extent
of 15% as the new process is significantly energy efficient.
Going ahead with the option under consideration would bring about the following incremental
cash outflows for DuoLever company.
 The company would have to arrange for a debt of $ 20 million for purchase of plant and
machinery for the manufacturing of the recycled sachets. A flip side to this investment is
that depreciation would be available which would facilitate lowering of tax outflow for
the company on account of project.
 The expenses in regards to selling, administration and general support activities would be
incurred amounting to $ 2 million per annum.
Considering the above cashflow information provided along with the relevant information
offered in the case, the NPV based on incremental cashflows is estimated as follows.
Option 2:
This option would involve a licensing arrangement by the company whereby patented
technology would be licensed to a contract manufacturer that in turn would supply the sachets to
the company at the existing price only. The profit margins for this manufacturer would be
derived through the lower manufacturing cost on account of energy efficiency. For the company,
licensing would mean that the manufacturing setup would not be required and thereby it would
not have to assume extra debt of $ 20 million. Additionally, the company would save on
administration costs to the extent of $ 1 million per annum. Considering the above cashflow

information provided along with the relevant information offered in the case, the NPV based on
incremental cashflows is estimated as follows.
Scenario Analysis
A key flaw with the analysis carried out above is that it is based on figures which are essentially
future estimates. These are based on key assumptions about the future which may differ and
hence cause a disruption in these input values. As a result, scenario analysis can provide relevant
performance under the two given choices based on extreme scenarios (Parrino and Kidwell,
2014). Both these scenarios have an underlying probability of 0.3 each and are referred to as
optimistic and pessimistic scenario.
Under optimistic scenario, the economic performance exceeds the current expectations based on
which projects were based. As a result, the following revisions have been made.
 Original sales growth forecasted at 5% and not 4% p.a.
 The effect of introduction of eco-friendly sachet contributes to 3% increase in sales and
not 2%.
 The variable packaging cost witnesses a decline of 16% and not 15%.
 On account of higher sales, the increase in variable costs witnesses an increase of 3.5%
p.a. and not 3% p.a.
Under pessimistic scenario, the economic performance underperforms the current expectations
based on which projects were based. As a result, the following revisions have been made.
 Original sales growth forecasted at 3% and not 4% p.a.

 The effect of introduction of eco-friendly sachet contributes to 1% increase in sales and
not 2%.
 The variable packaging cost witnesses a decline of 14% and not 15%.
 On account of lower sales, the increase in variable costs witnesses an increase of 2.5%
p.a. and not 3% p.a.
Based on the above analysis, the NPV computation for the two options is summarized below
(Mayer, McGuigan and Kretkow, 2015).
Sensitivity Analysis
The focus of the scenario analysis was to check the impact of changes in the benefit for the two
options. Another imperative factor to which the project feasibility may be sensitive to is the
overall cost of capital or discount rate. These is showcased based on relevant excel outputs
highlighted below.
Option 1
Apparently, the project feasibility is dependent on ensuring that the cost of capital remains check
as high deviation from the present value (7%) may render this option as financially unviable and
values destructive for shareholders.
Option 2

The above sensitivity analysis paints a contrasting picture as compared to option 1 as very high
adverse movements in the discount rate do not cause any significant deterioration of NPV and
project viability is not threatened.
Recommendation
From the perspective of shareholder wealth maximization, it would be advisable that in case of
mutually exclusive projects, the one which offers higher positive NPV is the most suitable one.
For the given situation, this option would be licensing. Also, from the risk perspective this is
superior as even in worst scenario , it is highly unlikely that NPV would be negative. Hence, the
company should proceed with this. But before taking a final call, relevant qualitative aspects may
also be considered as the given analysis is limited to quantitative analysis (Arnold, 2015).
Yours Sincerely
STUDENT NAME

References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management, pp. 156
Mayer, R. C., McGuigan, J. R., and Kretkow, W. J. (2015).Contemporary Financial
Management , 10th ed. London: South- Western College Publisher, pp. 189
Ross,S.A., Tryaler,R., Bird, R.,Westerfield, R.W. and Jorden,B.D. (2015) Essentials of Corporate
Finance. 2nd ed. New York City: McGraw-Hill, pp. 171
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley
Publications, pp. 203-204

Appendix
Option 1
Option 2