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| Allegro Technologies Co (ATC) Allegro Technologies Co (ATC), a listed company based in Europe, has been involved in manufacturing motor vehicle parts for many years. Although not involved in the production of complicated engine components previously, ATC recently purchased the patent rights for $2m to produce an innovative energy saving engine component which would cut carbonbased emissions from motor vehicles substantially. ATC has spent $5m developing prototypes of the component and undertaking investigative research studies. The research studies came to the conclusion that the component will have a significant commercial potential for a period of five years, after which, newer components would come into the market and the sales revenue from this component would fall to virtually nil. The research studies have also found that in the first two years (the development phase) there will be considerable training and development costs and fewer components will be produced and sold. However, sales revenue is expected to grow rapidly in the following three years (the commercial phase). It is estimated that in the first year, the selling price would be $1,000 per component, the variable costs would be $400 per component and the total direct fixed costs would be $1,500,000. Thereafter, while the selling price is expected to increase by 8% per year, the variable and fixed costs are expected to increase by 5% per year, for the next four years. Training and development costs are expected to be 120% of the variable costs in the first year, 40% in the second year and 10% in each of the following three years. The estimated average number of engine components produced and sold per year is given in Table 1.  There is considerable uncertainty as to the exact quantity that could be produced and sold and the estimated standard deviation of units produced and sold is expected to be as much as 30%. Machinery costing $120,000,000 will need to be installed prior to commencement of the component production. ATC has enough space in its factory to manufacture the components and therefore will incur no additional rental costs. Tax allowable depreciation is available on the machinery at 10% straight line basis. It can be assumed that, depending on the written down value, a balancing adjustment will be made at the end of the project, when the machinery is expected to be sold for $40,000,000. ATC makes sufficient profits from its other activities to take advantage of any tax loss relief available from this project. Initially, ATC will require additional working capital for the project of 20% of the first year’s sales revenue. Thereafter every $1 increase in sales revenue will require a 10% increase in working capital. Although this would be a major undertaking for ATC, it is confident that it can raise the finance required for the machinery and the first year’s working capital. The financing will be through a mixture of a rights issue and a bank loan, in the same proportion as the market values of its current equity and debt capital. Any annual increase in working capital after the first year will be financed by internally generated funds. Largo Co, a company based in South-East Asia, has approached ATC with a proposal to produce some of the parts required for the component at highly competitive rates. In exchange, Largo Co would expect ATC to sign a five-year contract giving Largo Co the exclusive production rights for the parts. Staccato Innovations Co (SIC) is a listed company involved in the manufacture of innovative engine components and engines for many years. As the worldwide demand for energy saving products has increased, it has successfully developed and sold products designed to reduce carbon emissions. SIC has offered to buy the production rights of the component and the machinery from ATC for $113,000,000 after the development phase has been completed in two-years’ time. Additional data ATC, Extracts from its latest Statement of Financial Position  ATC shares have a face value of $0.50 per share and are currently trading at $3.50 per share. ATC’s beta has been quoted at approximately 1.3 over the past year. SIC, Extracts from its latest Statement of Financial Position  SIC shares have a face value of $1 per share and are currently trading at $3.00 per share. Its loan notes are trading at $102 per $100. SIC’s beta has been quoted at approximately 1.8 over the past year. Other data Tax rate applicable to ATC and SIC 20% It can be assumed that tax is payable in the same year as the profits on which it is charged. Estimated risk-free rate of return 3% Historic equity market risk premium 6%Required: (i) Assesses whether ATC should undertake the project of developing and commercialising the innovative engine component before taking SIC’s offer into consideration. Show all relevant calculations. (ii) Assesses the value of the above project if ATC takes SIC’s offer into consideration. Show all relevant calculations (iii) Discusses the approach taken and the assumptions made for parts (i) and (ii) above. (iv) Discusses possible implications of ATC entering into a contractual agreement with Largo Co. Include in the discussion suggestions of how any negative impact may be reduced. |