Assignment 1: Memo to Management
High Tech Fun Pty Ltd is a medium-sized computer game development and marketing firm that is considering the introduction of a new product. The firm does not have a clear project appraisal process评估流程. In the past, projects have been evaluated in an ad hoc manner with varying levels of sophistication depending upon the manager taking 'ownership' of the project. Consequently, project success has been rather hit and miss. Under recent intense pressure from the board of directors to increase the value of the firm, the CEO John Jones thinks that something needs to be done to improve the transparency, sophistication and consistency of project appraisal within the company. When John heard about this most recent new product proposal, he decided to call you in to help in the appraisal process.
Your task, as negotiated with John and specified in the consultancy documentation's scope, covers three key areas:
1. analyse base case figures for the new product, providing details such a tables of figures, assumptions, and a description and justification of the decision rule(s) used to assess the project1; 2. provide a recommendation based on base-case analysis; and 3. advise on further analysis that should be undertaken with respect to the project (but you do not have to undertake that further analysis).
John directed you to the relevant staff within the firm that could help you collate base case figures for the project. Your first stop was the sales department. Sales staff expect the new product to have sales of $8 million in its first year, increasing by 50% in its second year. Sales in its third year will remain the same as in its second year. Due to short product life-cycles in this industry, in its fourth and fifth years, sales of the new product are expected to decline to one-half and one-quarter of peak annual sales, respectively. After this time, no material sales (or associated expenses) are anticipated.
Based on past experience with similar products, the accounting department, in consultation with the production department, has estimated that annual cost of goods sold for the new product will be 65% of total annual sales revenue, while annual selling, general and administrative costs will be 25% of total annual sales. In addition to these estimated costs, there are several costs specifically related to this new product proposal:
Specialised new production equipment costing $700,000 will be required. At the end of its life (which coincides with the new product’s life cycle), the equipment is not expected to have any salvage value. The equipment cost will be depreciated but there are two methods that could be used: (1) straight-line; or (2) diminishing value at a depreciation rate of 40% per year with the rate being 100% in the final year of the project.
1 Since the company currently has no clear project evaluation policy or process, John has left it up to you as to what decision rule(s) you apply in assessing the project. He has asked, however, that you use a decision rule(s) the company can (and should) apply in future project analyses. Therefore you need to describe the rule(s) you decide to use and explain/justify why that rule(s) was chosen.
The production manager has pointed out to you that the new production equipment will have to be set up in a part of the factory currently used to store spare parts. Since there is no other room in the factory, the spare parts will have to be moved to a commercial storage facility further down the street. Rental of sufficient space at the storage facility will cost $26,000 per year paid in advance. Additional investment in new working capital will also be required. Past experience with similar products suggests that 30 cents of net working capital is required to support each dollar of the coming year's sales. The accounting department has also advised you of a number of one-off expenses associated with this new product. Firstly, one-off tax-deductible introductory expenses of $300,000 during the first year of the project are anticipated. Secondly, $1.75 million has been paid in the past year developing and test marketing the new product. No more similar expenses are expected.
From your conversations with staff at High Tech Fun, you conclude that the risk of this new product project is similar to the company’s existing projects. Therefore, you adopt the company’s cost of capital, which you estimate to be 14%. Furthermore, you determine that the company’s tax rate is 30% rate.
With all the above information on hand, you start working on the analysis. You decide to report back to John by way of a memo. You decide to include, at the beginning of the body of your memo, a half page (maximum) executive summary your method, key figures and findings, and recommendations. The remainder of the body of the memo will address in detail the three key areas specified in the consultancy documentation's scope. Since you recognise John is a busy person, you will limit your memo to four A4 pages.
Your memo should include all necessary supporting calculations. Table format for presenting numerical analyses is preferable. If you use a spreadsheet it should be embedded into your assignment document at the place where it is discussed. Ensure that readers will be able to easily follow what you have done and state any assumptions. You may wish to use notes to your table that clarify calculations, details and/or assumptions where this is not clear from the table itself.
Marks will be allocated as follows:
Analysis of base case figures (11 marks) Description and justification of the evaluation method(s) chosen (2 marks) Recommendation on the project based on base case figures (1 mark) Recommendations for further analysis of the project (4 marks) Memo format and professionalism of communication (2 marks).
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