CyberLab: A New Business Opportunity for PRICO (A)
CyberLab has developed a machine that has the capability of revolutionizing the lab robotics industry. The market for the product, however, is very tight with some stiff competition. In order to expand, the company has offered 30% of its equity stakes, along with marketing rights of the product, for a total of $1 million. The three elements of the deal (the equity stake, the marketing agreement, and the technology patent) need to be individually valued before PRICO can accept the deal. The decision will be based on whether or not the total of the values assigned to each element is greater than the investment, or not.
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As PRICO examines the offer put on the table by CyberLab for an equity investment, the company’s management has to determine whether or not the offer is worth investing in. CyberLab has offered a 30% stake in its company, along with marketing rights to its sole product, the CyberLab 800, for a sum of $1 million. From an evaluation standpoint, this deal consists of three different elements packaged into one. First is the 30% stake in CyberLab; second is the ability to buy CyberLab’s product at cost and sell it on premium through PRICO’s own, well established, promotion, sales and distribution network; third is the patent on the technology that CyberLab 800 comprises of.
For the offer to be profitable for PRICO, the sum of the valuation of the company (PRICO’s share i.e. 30%), the value of the marketing proposal, and the value of the patent for PRICO has to be more than $1 million.
The value of CyberLab to PRICO will be the future expected net cash flows of CyberLab discounted at the cost of capital for the firm. These cash flows will have to be projected assuming that the deal, currently on the table, is executed, and CyberLab has received $1 million to fund its expansion, and not the current expectations. This is because PRICO will be concerned with the post-acquisition value, or CyberLab’s potential rather than the current value.
Now based on the facts of the case the market for a sample preparation machine was significant, with over 18,000 sites requiring the device presently. However, penetrating the market was not going to be easy considering the big names (such as Zymark, which held 42% of the market share, and Micromedic, which held 17% of the market share) that represented the competition. Furthermore, the lucrativeness of the market was also attracting many, huge, new entrants like Hewlett Packard. Therefore, even though CyberLab 800 was more efficient and less costly, CyberLab (being a small and relatively new company) was only expected to capture 5% of the market share initially. The growth in the overall market and the competition, also means that CyberLab’s share in the market would be growing to 7.5% only, by year three.
Each unit was to be transferred by CyberLab to PRICO at a pre agreed rate of $25,000. Based on the small scale production made earlier by CyberLab, the direct materials and labor cost to manufacture each unit would be $8,651. The overhead expenses are expected to be $138,000 in the first year, and then steadily increase (due to inflation and rising utility costs) to $196,430 in year two and $207,641 in year three. Similarly, general administration expenses are expected to be $258,044 in year one, and then rise (due to inflation and rising utility costs) to $343,047 in year two and $344,908 in year three. Depreciation of fixed assets will be deducted on a reducing balance basis with $16,000, $9,600, and $5,760 deducted in years one, two, and three respectively. Using the applicable tax rate of 40%, these figures result in a net profit after tax of $37,246 in the first year, $131,596 in year two, and $165,294 in year three.
Based on the production made in the smaller facility, previously by CyberLab, the change in working capital requirements is expected to be an increase of $47,176 in year one, increase of $58,841 in year two, and increase of $72,912 in year three. The net profit after tax, less the depreciation charge, after adjusting for working capital changes, gives net cash inflow of $6,070 in year one, $82,355 in year two, and $98,142 in year three. Using the same assumptions, the terminal value of all subsequent cash flows comes out to be $1,750,199. All cash inflows discounted at the cost of equity (13%) result in the total value of the firm of $1,350,861. Since PRICO is going to be getting 30% of the stake in CyberLab’s equity, the company’s share of the total value is going to be $405,258 (30% of $1,350,861).
The second element in the offer made to PRICO is the exclusive right to market CyberLab’s products at a premium from the charged transfer price, using the company’s own sales and distribution network. The transfer price agreed is $25,000, while PRICO expects to sell each unit for $32,470. This gives a gross margin of $7,470 per unit to PRICO. As mentioned before, market dynamics and growth will determine the product’s penetration, but PRICO is expected to sell 20, 47, and 51 units in year one, two, and three respectively (owing to the assumptions mentioned before).
Total selling and general administration expenses are expected to rise with sales and inflation from $188,400 in year one to $268,200 in year two and $270,600 in year three. These costs include the costs of sales staff and other resources that will be diverted in marketing CyberLab 800. This is because, based on the facts given in the 'case' these resources are not idle, and utilizing them cannibalizes the focus on the existing portfolio of products. Therefore, these costs should be allocated to this marketing project. Had these resources not being utilized to capacity in regular operations, these costs would not have been included in making the pro-forma cash flow estimates.
Given the assumptions mentioned, the marketing rights will yield net after tax profits of $16,938 in year one, $49,734 in year two, and $66,222 in year three. Accounting for the expected net working capital requirement changes of $28,249 in year one, $45,783 in year two, and $49,679 in three the expected net cash inflow is attained. In year one, the expectation is a net cash outflow of $11,311, and in year two and three net cash inflows of $3,951 and $16,543 respectively. Extrapolating the assumptions indefinitely the terminal value of $295,015 is yielded. Discounting all the cash flows, and the terminal value, at 13%, and accounting for the additional investment requirements of $150,000, the total value of the marketing agreement comes out to be $59,010.
The value of the patent is subjective as there is no direct benefit to be reaped from it from a financial perspective. There are two reasons why the patent is worth almost nothing, monetarily, for PRICO. Firstly, the deal only gives the company rights to market the product, and not to manufacture it. This means that PRICO doesn’t really have control over the technology that comprises CyberLab 800. Secondly, the recent offer made to CyberLab by Sperling Equipment Co. renders the ‘exclusive’ nature of the deal. If another company markets the same product, then PRICO would be competing with for the same customers. Therefore, from a current standpoint, the patent should not be given any value by PRICO.
With a total value gained of $464,268 ($405,258 for the stake in CyberLab, and $59,010 for the marketing agreement), the investment of $1 million is not worthwhile. There is a dire need to renegotiate the deal. PRICO should ask for a higher percentage of stakes in equity. Settling for a lower transfer price is not advisable, because it will affect the value of CyberLab, and thereby the over deal. Changing the transfer price will merely transfer value from stakes in CyberLab to PRICO’s marketing agreement. One possible solution would be to offer $460,000 for a 30% stake in CyberLab and the marketing agreement while issuing the remaining $540,000 as loan to the company, payable over a long-term period.
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