Alla Aeroshoes is in the business of designing and manufacturing running shoes f

Question

Alla Aeroshoes is in the business of designing and manufacturing running shoes for long distance runners. They are considering a $100 million upgrade to their production line for the iPhone/iPad/iWatch connected shoe that has Bluetooth connectivity. The potential cash flow is estimated at net revenues of $460 million per year for four years. Recently, they were advised of potential patent infringement and to eliminate this problem they are considering buying a license. SohnCo will sell a license that is good for four years of exclusive use of the patent and associated intellectual property. Alla Aeroshoes uses a corporate MARR of 14% and their risk-free alternatives are 6%. The VP of Engineering at Alla Aeroshoes estimates market volatility in demand is 50%. The VP of Marketing estimates market volatility in demand at 35%. 1. Since the VP’s trust you, they asked you to figure out the most they should pay for a license from SohnCo. 2. Alla Aeroshoes is known to be liberal in ignoring intellectual property claims. Imagine they just go ahead with the project as stated above. (In other words, they decide not to pay for the license.) SohnCo aggressively protects their property and sues immediately. Sometime in year 3, (from the start of the effort) a court decision requires Alla Aeroshoes to reimburse SohnCo $500 million. They pay at the end of year 4. How does this strategy work for them? Are they better off licensing or being aggressive?

Explanation / Answer

1. We need to calculate the NPV of the project. The lowest volatility level of demand is 35%. So the least to which annual revenue would fall would be = 460 * (1-35%) = 299

Discount Rate = MARR = 14%, Initial Investment = -100, Annual Cash Flow = Revenue = 299 , n = 4 Years so NPV = 771.20

NPV = - CF0 + CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4

NPV = -100 + 299/(1.14)^1 + 299/(1.14)^2 + 299/(1.14)^3 + 299/(1.14)^4 = 771.20

So, $ 771.20 million is the maximum amount they can pay for license.

2. Using demand as $ 460 million annually. We need to compare the NPV of the project in two cases i) Aggressive ii) Licensing

To calculate NPV use excel NPV function or refer the formula below:

NPV = - CF0 + CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4

i) Aggresive:

i) Licensing:

So, Alla Aeroshoes better off with aggressive policy as it has higher NPV compared to licensing.

Year 0 1 2 3 4 Investment -100 Revenue Cash Flow 460 460 460 460 Reimbursement to SohnCo -500 Net Cash Flow (CF) -100 460 460 460 -40 Discount Rate/MARR 14% NPV 944.27

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