PLZ PLZ HELP

QUESTION 1

Rectangle Space is a Cwmbran based company which manufactures solar powered bricks that can be used pave a drive or garden path with solar lights. Over the past three years, Rectangle Space has witnessed a steady fall in its sales due to numerous complaints of faulty products. Rectangle Spaces director Mr. Bright claims the company has undergone a thorough quality control audit and all faults have been rectified. Although the quality of the products has improved, Mr. Bright is worried the negative publicity will continue to depress sales in the UK. To improve the companys financial health, Mr. Bright has decided to target the Icelandic market by setting up a joint venture with an Iceland based company known as Aurora Limited.

Aurora has expressed an interest in using Rectangle Spaces technical expertise and patent rights to open a domestic production facility. Aurora believes once production commences, it will be able to sell the brick to national and international customers.

Due to the lower labour costs in Iceland, Aurora anticipates there will be a saving of 45% to manufacture in Iceland as opposed to Cwmbran. If the agreement is successful Rectangle Space will be required to:

• Provide 45% of the total capital of 30 million Icelandic krna (ISK) to set-up a production facility in Iceland. 5 million ISK of the total capital will be used to acquire working capital, the remaining 25 million ISK will be used to purchase depreciable fixed assets.
• Grant patent rights to produce the brick in Iceland. The patent will have a life of four years until they expire.
• Provide ongoing technical expertise to assist the joint venture.

The joint venture agreement will be for a period of 4 years. Thereafter, Aurora will buy Rectangle Space's share in the joint venture for 10 million ISK. The joint venture agreement will entitle Rectangle Space to a 45% share of the profits or losses.A standard brick is expected to sell in Iceland for a price of 6000 ISK per unit in year 1. Prices will then increase by the expected rate of inflation in Iceland. It is expected 10,000 units will be sold in Iceland in the first year, this will rise by 10% each year over the next three years.

The joint venture is also expected to sell 5,000 units of the brick each year to the USA at a constant price of $45 per unit. Rectangle Space currently exports similar brick to the USA, providing a pre-tax contribution of 150,000 per year. Because of the cheaper price of brick manufactured in Iceland it is expected that 50% of these exports will be lost.

Provision of initial technical assistance will cost Rectangle Space 120,000 and ongoing aid would cost 30,000 per year in salaries, at current prices. Neither would be tax allowable expenses in Iceland, although the salaries would be tax allowable in the UK. There are no cash costs associated with using the patents, however, this will mean that the patent cannot be sold to another company which is willing to pay a constant sum of 45,000 per year to use the patent. In year 1, direct costs in Iceland will be 1000 ISK per unit, and fixed costs 3 million ISK per annum; both these costs are expected to increase by the inflation rate in Iceland.

Tax allowable depreciation in Iceland is 50% per year on a reducing balance basis. The tax rate in Iceland is 20% and in the UK 30%. A bilateral tax agreement exists between Iceland and the UK. Tax is payable one year in arrears.

Expected inflation rates (%):

	UK	Iceland	USA
Years 1 2	3	2	5
Years 3 5	4	3	5

Spot exchange rates:

Icelandic krna ISK 132.00/

Icelandic krna ISK 178.05/US$

Rectangle Space's cost of capital is 10%. Due to the risk associated with manufacturing overseas, Mr. Bright is proposing to use 12% as the cost of capital for the joint venture.

Required:

You are a management accountant of Rectangle Space. Prior to finalising the joint venture agreement, Mr Bright has approached you for advice. Write a short memo addressed to Mr Bright evaluating whether Rectangle Space should participate in the joint venture. Within your memo you should include:

i) The Net Present Value of the project in UK s using a discount rate of 12%.

2. A recommendation on whether Rectangle Space should enter the joint venture based on the calculations in i).

iii) Using Rectangle Spaces case study, evaluate the implications of using an organic growth strategy.

Summarise the potential negative implications for Rectangle Space for entering into a joint venture agreement with Aurora.

State clearly any assumptions that you make.