Scenarios

It is 31th December 2018.

Your team of three people form a financial analysis team at Aussie Finance Consulting (AFC), a renowned financial institution. The executive management of AFC has assigned you a task to carry out a special project for its client Victorian Telecomm Limited (VTL), which requires preparing a business report. This report will be presented to AFC executive management and also to the senior management of VTL.

VTL is a telecommunications company. They provide a full range of telecommunication services to corporate and government customers including fixed line voice, data networks and mobility services through a range of carriers offering choice, control and cost reduction.

VTL has been in the business for 20 years now. It is well established and profitably running business thus far. VTL has recently undertaken a market study which costed them $50,000. Findings of the study indicate that it is critical for VTL to upgrade their infrastructure to meet the demand of its customers. They plan to do the upgrade systematically in stages gradually over next few years. They also need to plan their finances to fund the upgrade plan.

For the upgrade, they need some critical hardware components. The management has identified two options: (1) In-house production which requires the company to establish their own production facility; and (2) Outsourcing which implies external procurement of the necessary hardware.

After a careful analysis, the management has worked out the following details for the two options:

Option 1: In-house production

The purchase and installation of the machinery shall cost $3,000,000 and has an economic life of twelve years. The machinery is expected to depreciate to zero on a straight-line basis over its economic life. However, the company expects to keep their in-house production for only seven years. At the end of Year 7, the machinery can be sold at an estimated market value of $1,500,000. Currently VTL has a warehouse which generates a rental income of $200,000 each year. To save on investment costs, the management intends to convert this warehouse into a factory for manufacturing various hardware components. The conversion cost is estimated to be $100,000 and treated as a capital expense. VTL also requires training its staff on the new machinery immediately after the installation. Training fees are expected to be $10,000 and fully tax-deductable. Annual maintenance cost of the machinery is $150,000. The collective cost of the hardware components to be manufactured is estimated to be $2,000,000 in Year - 1 with an expected increase of 5% per annum in the following years. VTL also needs to invest in necessary development software and maintain the licenses. The negotiated licensing fee for the software is estimated to be $50,000 per year. Finally, the management estimates that they shall need additional net working capital of $25,000 at the beginning of the production with an expected increase of 5% per annum in the following years.

Option 2: Outsourcing

Alternatively, VTL can contract with a firm named Innovative Equipment Limited (IEL) which is specialised in manufacturing the required hardware. Based on the types and expected number of units VTL would need, IEL management has quoted a total cost of $3,000,000 in Year 1 which will continue to grow at 7% per annum to keep up with the rising cost and forecasted growth in the number of the required units. IEL, however, has offered this rate on a condition of a five-year contract. Also, IEL requires that VTL pays 60% of the expected cost for a year in advance at the beginning of that year. From the accounting perspective, equipment that are procured from IEL may be classified as cost of goods sold in the books of VTL. Hence, they will be treated as operating expense for the business. Furthermore, as in Option 1 VTL still needs the warehouse to store the hardware.

You are required to analyse the two given options and make recommendations to VTL about the option they should choose.

Balance Sheet of VTL as of 31 December 2018

Assets

Cash at bank $ 500,000

Accounts receivable $ 550,000

Inventory $ 700,000

Marketable securities $ 6,750,000

Plant, machinery and equipment $ 110,500,000

Intangible assets $ 30,000,000

Land and building $ 23,000,000

Total $ 172,000,000

Liabilities

Accounts payable $ 300,000

Bank overdraft $ 550,000

Commercial bills (due 30th Jun 2019) $ 2,000,000

3.25% Coupon bonds (due Dec 2028 issued @$100 each) $ 100,000,000

Shareholders' Fund

Common stock 33,500,000 @ $2 each $ 67,000,000

Retain earnings $ 2,150,000

Liabilities + Shareholders' Fund $ 172,000,000

Which of the two options should VTL pursue?

The first part of the analysis requires you to work out the Weighted Average Cost of Capital (WACC) for VTL with the help of the given information and given data.

Secondly, evaluate the two options using NPV analysis and clearly identify which of the two alternatives is better for VTL.