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.
For each option:
a. What are the incremental cash flows each year?
b. What is the net present value?
c. What is the IRR?
What option should Vaporware choose and why?
In addition to your financial analysis, what other considerations might be important to your decision and what other information might you want to have?