DuoLever Limited operates in the personal care (e.g. skin and hair care products) industry. All its products are sold in plastic packaging and a significant proportion in multi-layer sachets (or pouches)2.

Managers at DuoLever are acutely aware of the increase in world production of plastic and the environmental impact of plastic waste ending up in landfills, rivers and oceans. For example, it is estimated that 8 million metric tons entered the ocean in 2010 and this annual amount is predicted to more than double by 2025.

To help develop a closed-loop system related to the company's products, DuoLever has invested around $50 million in soft plastic recycling research, development and pilot testing. The outcome is a new and efficient method for recycling sachet waste. In fact, their recycling method is more energy efficient than producing virgin sachet plastic, reducing energy usage by 83%. The output plastic is of such high quality it can be used in food grade packaging applications. Currently, no other recycling method in the market can achieve this.However, they have two options.

Option 1:

The recycling production option requires an upfront investment in plant and equipment of $20 million, which will be depreciated to a zero book value on a straight-line basis over 5 years. The plant will provide sufficient capacity to meet the company's forecast plastic packaging needs over the period of its life. After this, it is expected that the plant will have no salvage value and will be updated using new and better technology. Financing for the plant and equipment will be via a new 5 year debt issue, resulting in interest costs of $1.4 million payable at the end of each year.

Producing recycled plastic has several financial benefits for the company. First, sales revenue of the company's existing products, which will be packaged in the recycled plastic, is predicted to increase due to consumer demand for environmentally responsible products. Excluding this benefit, the company's forecast sales revenue for the coming year is $200 million and this is expected to grow by 4% each year after that. The benefit of recycled packaging is expected to increase these sales forecasts 2% during the 5 year life of the project.

The second benefit is that the cost of plastic packaging for the company's existing products will decrease. The recycled plastic will be cheaper than buying virgin plastic due to lower energy costs and avoiding a supplier margin. The reduced energy costs will shave 15% off total variable packaging costs, currently (without recycling) estimated at $22 million for the coming year and expected to grow by 3% per year after that. Avoiding a supplier margin will reduce total variable packaging costs by 10%. However, the benefits of avoiding the current supplier margin will be offset by the need to pay a new partner, Clean World Ltd, who will set up a plastic waste collection system to supply sufficient raw material for the recycling plant. Apart from these changes, it is expected that variable costs and net working capital will be equivalent to existing forecasts. However, an additional $2 million annually in selling, administrative and general expenses directly related to the project (excluding depreciation) will be incurred.

Option 2:

Option 2 involves licensing use of the patented recycling method to another company, Clean World Ltd, which has shown interest in taking on the entire project, not just supply of raw material. Initial negotiations between DuoLever and Clean World have reached some agreement on what the terms of the arrangement would involve. Clean World would produce recycled plastic using DuoLever's method for the next 5 years and all output during that time would be supplied exclusively to DuoLever for the same cost as DuoLever's existing virgin plastic supply forecasts. This means that Clean World would capture the energy savings associated with the new recycling method, along with a supplier margin. The benefits for DuoLever would be no initial outlay for plant and equipment and locked in packaging materials supply costs for the next 5 years. DuoLever would also retain the ability to market the environmentally responsible characteristics of its recycled packaging and so retain the expected additional sales revenue benefits of Option 1. Annual selling, administrative and general expenses would be just $1 million annually under Option 2, as no additional production administration would be required.

Other information:

DuoLever has an 8% weighted average cost of capital and is subject to a 25% tax rate on its income.

The company faces making a decision whether to

1. add production of recycled sachet plastic to the company's portfolio of businesses OR
2. license use of the patented method to Clean World Ltd?

QUESTION: Undertake a financial analysis of the options and recommend the best option