Bluebottle Ltd

Bluebottle Ltd is a manufacturer of drones. The company has been involved in drone production over the last five years and has successfully created a gaming product called the The Game of Drones which has been selling successfully. It is expected, however, that returns will decline in the next five years as new products compete and technologies improve. The directors of Bluebottle Ltd want to expand the use of their technology for other purposes outside of the gaming sector for a different commercial use. They have most recently been researching the use of their drone technology for making deliveries of small parcels. They have been in discussions with Danube Inc one of the worlds largest online distributors about the potential use of a drone product in their business, to deliver small parcels to their customers.

The directors of Bluebottle Ltd have now developed a new prototype (2ME2U) for use by Danube Inc. The directors have already committed 300,000 in the last two years on research and development of the prototype of 2ME2U and they are now considering whether to progress to the next stage of investment to develop the product for commercial use for delivery of small parcels. Danube Inc has proposed a five-year deal whereby they will use 2ME2U in a small number of their warehouses alongside their traditional postal services for two years and thereafter widen the use across a greater number of their warehouses from years three to five of the agreement.

The current premises of Bluebottle Ltd for manufacturing the product The Game of Drones will not be sufficient for the next stage of developing the 2ME2U drones. The directors of Bluebottle Ltd have decided that to accept the Danube Inc project they will need to switch from their current product development premises to a new location. The equipment currently used will have a zero scrap value after disposal costs have been taken into account and cannot be re-used for the 2ME2U, if a decision is taken to go ahead with the Danube Inc agreement. The forecast cash flows from sales of The Game of Thrones product are shown in table 1.

Year
1	90,000
2	65,000
3	55,000
4	45,000
5	30,000
Table 1: Net cash flows estimated from the Game of Drones

The rent and insurance cost for the premises and equipment for The Game of Drones is 15,000 and 5,000 per year respectively. Other overheads incurred from the current premises are 4,000 per year. The directors have sought a potential buyer for the intellectual property rights of The Game of Drones and a potential sale of 50,000 is expected if the Danube Inc agreement is progressed.

To develop the prototype of 2ME2U for commercial use by Danube Inc, the directors of Bluebottle Ltd have asked the financial controller of Bluebottle Ltd, Ms Prudence Compteur, to estimate capital expenditure, sales and the various costs for the 2ME2U project. Prudence has compiled a list of the costs for the capital expenditure of the 2ME2U and is shown in table 2.

Cost
Prototype research and development	300,000
Machinery and equipment	450,000
Installation costs of machinery	25,000
Factory set-up costs	40,000
	815,000
Table 2: Total Capital Expenditure Relating to 2ME2U

In addition to the capital costs, the delivery and unpacking of the machinery and equipment is estimated to cost 15,000. Prudence has built into her future cost assumptions that the machinery and equipment will have a re-sale value of 50,000 at the end of the useful life of the product. Disposal costs are estimated at 20,000. Additionally at the end of the five-year project it is envisaged that the 2ME2U drones will have a value for future use. Prudence has estimated the value as being, on average, 150 for each drone. This is based on the assumption, that the total number of drones manufactured in the five-years of operation are still in working order. To calculate this she expects all of the drones developed over each of the five years to be in operation at the end of the agreement term. Use and technical obsolescence has been built into the average price. The drones may be for future contracts of Bluebottle Ltd or re-sale to another manufacturer.

The fixed overheads for the new premises are expected to be rent and insurance costs of 35,000 per year over each of the five years, with the factory being used solely for the 2ME2U project. The heat, light and maintenance costs are assumed to be 20,000 per year for the first two years then increasing by 5,000 each year from years 3 to 5 as production is planned to increase. To fulfil the first year of product development an immediate increase in the working capital to support operations will be needed of 50,000 before operations commence and this should be recovered at the end of year 5.

Prudence has also generated an additional number of important price and cost assumptions for 2ME2U. It is expected that the price point will be at 1,000 per drone. Danube Inc want there to be a guarantee that there be no price rise over the period. The direct materials used in the manufacture of each drone will cost 400 per unit and the direct labour is estimated to be 325 per unit. It is also estimated that an additional member of staff in the quality control team is needed immediately at an annual salary cost of 35,000 per annum.

The agreement with Danube Inc will involve Bluebottle Ltd undertaking to fly the drones under licence. This will involve Bluebottle Ltd recruiting and training drone pilots, in addition to paying fees for licences where each warehouse is located. The agreement provides for Bluebottle Ltd to receive 7,000 per annum for each warehouse to reflect the Licence to fly for each warehouse location. Prudence, the financial controller, has estimated that the local licence cost and training of each pilot will be 5,000 per warehouse per year.

Danube Inc are interested in using the 2ME2U drone for the first two years in 15 of its warehouse locations worldwide to test its speed and reliability and also in countries where there are less air space restrictions on the intended flight patterns. In each of the locations it is envisaged that 20 drones will be used alongside the traditional methods by conventional postal systems in the first two years. Danube Inc would envisage placing order as shown in table 3.

Period	Number of warehouses	Number of new drones per warehouse
Year 1	15	20
Year 2	15	20
Table 3:Danube Inc demand for 2ME2U in years 1 and 2

From the remaining years of the five-year agreement Danube Inc have committed to ordering for warehouses and drone numbers as shown in table 4 as the minimum order.

Period	Number of warehouses	Number of new drones per warehouse
Year 3	25	30
Year 4	30	30
Year 5	35	30
Table 4: Danube Inc Minimum demand for 2ME2U Years 3-5

If the trial in the first two years goes particularly well Danube Inc would commit to adopting a more accelerated option to using the drones in larger quantities and across more warehouses. Table 5 illustrates what the accelerated option looks like in terms of demand.

Period	Number of warehouses	Number of new drones per warehouse
Year 3	50	50
Year 4	60	75
Year 5	70	100
Table 5: Danube Inc Accelerated demand for 2ME2U Years 3-5

The directors of Bluebottle Ltd believe there is a 60% chance of the orders in years 3-5 being at the minimum demand (table 4) and a 40% chance of there being an accelerated demand (table 5).

If Danube Inc go ahead with the accelerated option they expect Bluebottle Ltd to reduce the price by 10% from the initial price of 1,000 for years three to five of the agreement.

Prudence has estimated that variable costs of production for each drone under the accelerated option are expected to increase slightly as the additional drone orders will mean utilising new recruits to fulfil the volume of the order adding 2.5% to the total variable costs of 725. The heat, light and maintenance in years 3-5 would also increase from year 2 if the accelerated option is taken, by 25,000 in years 3 and 4 and by 75,000 in year 5 as the shift patterns rotate to cope with the additional volume of output. An additional supervisor will be needed to help co-ordinate orders in the accelerated option. This would add a cost of 45,000 per annum from year 3.

The directors of Bluebottle Ltd are anxious about undertaking this new venture and the switch from their existing product. They are equally excited at the prospect of potential success. Their normal payback period for new projects is 3 years but they do normally use a range of capital investment techniques to assess their potential returns and before they take a decision. With the information that Prudence, the financial controller, has gathered you are now being asked to assess the Danube Inc proposition.

Other Assumptions

Ignore taxation implications of the project.

Unless otherwise stated, assume that relevant cash flows occur at the end of each time period.

Cost of Capital for this type of project is 12%

For the switch from the existing Game of Drones to 2ME2U you are required to complete the following on behalf of the directors of Bluebottle Ltd:

1. ii. Calculate the incremental cash flows over the five year life of the agreement under the assumption of accelerated demand from Danube Inc;