Reference no: EM133432730
Piscataway valves decided to pursue development of a new product line for natural gas pipelines. The development effort has been successful and Piscataway is preparing to begin manufacturing and marketing the new product line next year.
Piscataway has learned that marketing to natural gas pipeline companies requires commercial skills and experience they do not have. Management has, as a consequence, decided to have a partner and are in serious discussions with Fargo Pipeline Services (FPS).
FPS has extensive experience marketing to natural gas pipelines and has the manufacturing capacity to produce valves as well.
FPS has submitted two proposals:
(a) FPS would manufacture and market the valves
(b) FPS would market the valves, Piscataway would manufacture the valves.
Piscataway needs to decide which, if either, of the proposals to choose.
For both proposals, Piscataway expects its natural gas pipeline product line to generate the following cash flows, excluding any payments to its partners and capital spending as described below.
| Year |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
| Product Line Cash Flow |
$2,850 |
$3,925 |
$6,350 |
$9,250 |
$11,050 |
$11,775 |
$12,450 |
$14,550 |
$14,550 |
$14,550 |
For Proposal 1 (FPS would manufacture and market the valves)
FPS would get an upfront payment (Year 0) of $11,150 and 35% of the above cash flows as compensation for its manufacturing the valves and commercial efforts.
For Proposal 2 (FPS would market the valves, Piscataway would manufacture the valves)
FPS would get an upfront payment (Year 0) of $2,750.
Piscataway will have to invest in manufacturing capacity: $10,750 in year 0 and an additional $6,555 in year 5
FPS would get 25% of the product line cash flows as compensation for its commercial efforts.
Part A
Piscataway's CEO and CFO have agreed on a 15% required rate of return to value Proposal 1 (FPS would manufacture and market the valves.)
Which required rate of return should the CEO and CFO choose to evaluate Proposal 2? Why?
10%
15%
20%
Part B
Using the rate of return chosen by the CEO and CFO for Proposal 1 and the return you chose for Proposal 2, which alternative would be best for Piscataway? (Use financial criteria only)
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