You are the founder and CEO of Vaporware Inc., a developer of systems enabling t

Question

You are the founder and CEO of Vaporware Inc., a developer of systems enabling the wireless charging of batteries in small portable devices. Your product, which is a small circuit board with proprietary hardware and software, will be sold to OEM customers who will package your module into a charging surface onto which portable devices simply need to be in contact to charge. You are excited with the early customer feedback you have gotten to your fully functional prototypes and now have to make a decision how to produce these in volume. In fact you have at least three companies who have specified the Vaporware system into their charging mats, and anticipate first year sales of 5000 units which will grow by at least 10% per year and that you average unit selling price will by $100.

You have narrowed the options down to two - develop in house manufacturing capability or outsource – and want to evaluate each over a 5 year time horizon. If successful, you expect to be making significant new investments by then so your assumption is that you are making a decision today that would support the business for 5 years.

In house: This option will require a $300,000 investment in equipment which has a 5 year useful life. You anticipate the production process will allow you to produce the system for $35 per unit (cost of goods sold). However, in addition to human resources directly involved in the manufacturing process you will have to spend an extra $100,000 per year which doesn’t necessarily show up in cost of goods. Vaporware will need to invest in inventory and accounts receivable to the extent of 15% of sales with a $50,000 investment initially for inventory.

Outsource: You have identified a potential partner that can produce your system on almost a “turn key” basis for $55/unit. This partner will purchase and hold required inventory, manufacture, test and transport for this price. Vaporware will still incur $20,000 of incremental support expenses annually and will also have to invest $150,000 up front to defray the partner’s set up costs. This $150,000 cannot be depreciated. Since the partner will invest in inventory the working capital requirements for Vaporware will only be 10% of sales with no initial investment.

Vaporware’s tax rate is 35% and assume a 20% cost of capital.
1) For each option:
a. What are the incremental cash flows each year?
b. What is the net present value?
c. What is the IRR?

2) What option should Vaporware choose and why?

3) In addition to your financial analysis, what other considerations might be important to your decision and what other information might you want to have?

Explanation / Answer

All Amount sare in $

Its better to Outsource due to more Net Present Value

Calculations Below

Incremental Cash Flow of In house Production With IRR 0 %

Incremental Cash Flow of Outsourse With irr 48%

PARTICULARS YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 TOTAL Sale (in Units) 5000 5500 6050 6655 7320.5 Sale (in value) 500000 550000 605000 665500 732050 3052550 Cost Of Goods Sold 175000 192500 211750 232925 256217.5 Extra Expense 100000 100000 100000 100000 100000 Depreciation 60000 60000 60000 60000 60000 Gross Profit 165000 197500 233250 272575 315832.5 Tax @ 35% 57750 69125 81637.5 95401.25 110541.4 Net Profit After tax (A) 107250 128375 151612.5 177173.8 205291.1 Initial investment(B) 300000 Initial working Capital 50000 75000 82500 90750 99825 109807.5 Increase In wc (c) 50000 75000 7500 8250 9075 9982.5 Incremental Cash Flow (A - B - C) -350000 32250 120875 143362.5 168098.8 195308.8 PV Factor @20% 1 0.833 0.694 0.579 0.482 0.402 Net Present Value -350000 26875 83941 82964 81066 78490 3336

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