Question

The Situation:

In the summer of 2015, Photonics, a leader in the production of biometric sensors, started to experience a decline in sales growth for one of their most popular products, OxyAlert. OxyAlert was launched in 2011 and quickly became the industry standard in analyzing the oxygen levels of surgically repaired tissue after emergency care procedures. In the first year of sales this product captured 25% of the market in post operation biometric devices. By the second year it had rapidly overtaken the industry leader with a 55% share of the market. The success of this product was primarily due to innovative features that were not found on any other product. Features such as wireless disposable sensor probes and advance analytic software allowed doctors to shorten the recovery time of their patients in ICU units, which decreased per patient ICU expense by 10%. Based on these innovative features Photonics was able to charge a premium for this product and establish themselves as one of the most profitable companies in the industry.

Several competitors have now closed the gap in product design and functionality. In the fall of 2014, SeaBridge, one of Photonics biggest rivals, launched the product TotalDiagnostic. This product contains similar disposable sensory technology as OxyAlert, however, it allows doctors to analyze a broader range of a patient’s biometrics. While this product was priced around 10% higher than OxyAlert, doctors had the added advantage of not only maintaining the same recovery rates but also decrease the rate of post surgical infection by 15%. By February of 2015, TotalDiagnostic had captured 30% of the market.

Photonics response was swift. They immediately reduced the price of OxyAlert by 20% in order to regain market share. From March through May, sales of OxyAlertrebounded. While profit margins of the company did take a hit, it appeared that the price reduction stabilized the company’s market share. Unfortunately, recent sales reports from June show that pre-orders for OxyAlert are significantly down. As the CFO of Photonics you are worried that OxyAlert has become an obsolete product and further price reduction will have very little impact on sales growth.

Background and History:

Photonics was founded in 2008 by Rachel Walker, a professor of Bioengineering. From 2001 through 2006, Dr. Walker authored several papers on photonic measuring systems and it’s applications in biometrics. By 2007 she developed a prototype sensor that that was extremely non-invasive to the patient. She realized that this type of sensor combined with advanced computer algorithms could quickly analyze oxygen levels in surgically repaired tissues giving doctors “real time” information on the likelihood that a patient’s body would accept or reject the repaired tissue.     

Dr. Walker believed that she had an important technology that could be highly profitable if she could find a way to commercialize it. Given the uniqueness of this technology she was able to obtain a patent in 2008. She felt fairly confident that her technology would be a major improvement in post-surgical care. However, several obstacles existed. The cost to turn this technology into a commercialized product was fairly substantial. However, more importantly, this was a highly disrupted technology that would require hospitals to change ICU and post operation processes. She wasn’t even sure if hospitals had a desire to change their current practices.

After interviewing several prominent hospital administrators, she concluded that that demand would be high if she could find a way to mass-produce her prototype at a cost that was on par with biometric sensors currently being sold to hospitals and other surgical centers. After several investor presentations, she was able to attract significant funding from a venture capital firm that specialized in funding small biomedical start-ups. With a $15 million dollar investment, Photonics was able to launch its first product, The BMD 1000, in January 2010.   

In the first three months of 2010, sales of the BMD 1000 were tepid at best. While the product design was innovative, it did not integrate well with the current technology employed by most hospitals. Based on the criticisms of this product, Dr. Walker and her engineering team went back to the drawing board. The redesigned product was named OxyAlert and was introduced to the industry with much fanfare in January of 2011. By July of 2011, Photonics had secured orders with several large health care facilities on the East Coast. One year later, OxyAlert become the standard in the biometrics device industry.

Solutions

All along, you and Dr. Walker have known that five years was the typical product life cycle in this industry. Fortunately, you employ some of the brightest engineers in the field who have been developing three new interesting products that could restore your company’s sales growth. The first product is an improved version of OxyAlert, codenamed “OxyAlertII”. The second product is completely new to the industry and will allow doctors in emergency rooms to diagnose pre-existing conditions of incapacitated patients through breathalyzer tests. This product is codenamed “AutoAnalytics”. The third product is a complimentary product to OxyAlert that will enhance OxyAlert’s diagnostic capabilities. This product is codenamed “Diagnostic Solutions”.

The following are brief descriptions of each product’s financial costs and revenue projections:

OxyAlertII

Your marketing department believes that this product will not completely replace OxyAlert, as there will still be some companies who will want the older and cheaper version. However, they do believe that there will be significant cannibalization of your old product. By introducing this new product, sales of OxyAlert is forecasted to steadily decrease by 20% each year over the next 5 years. First year sales of OxyAlertII are projected to be $15 million with a 10% increase in revenue each year over the next 5 years. In the prior two years your company has spent $1 million on the development of this project. To finish the development of OxyAlertII and create the manufacturing infrastructure to produce it, your engineers estimate that they will need another $20 million in equipment purchases. This equipment has a 5-year life. The manufacturing process for this product will be fairly automated. As a result, cost of goods sold will be only 45% of revenue, much lower than current company averages. Incremental SG&A will be 15% of revenue. Working capital requirements will be 8% of revenue. In order to successfully launch this product, your marketing department is requesting a one-time advertising budget of $2.5 million, which will be spent in the first year of sales.

“AutoAnalytics”

This product is neither a complimentary product nor a replacement product for OxyAlert. The launch of this product is intended to create a new product line by extending Photonics core competencies into the emergency response market. Prior years’ development cost for this product has totaled $1.5 million dollars. Your engineering team estimates that it will cost $10 million dollars in new equipment purchases to manufacture this product. The economic life of this equipment is also 5 years. Your marketing department forecasts first year revenue at $9.5 million with initial one time marketing expense of $1.25 million. Based on projected demand, revenue is expected to increase by 7% year over year for the next 5 years. Because of the lack of experience in manufacturing this type of product, your operations management team expects that costs of goods sold will be somewhat high at 55% of revenue. Incremental SG&A will be 13% of revenue with an additional working capital requirement of 10% of revenue.

“DiagnosticSolutions”

DiagnosticSolutions is a series of networked probes that will allow customers to use OxyAlert in more efficient ways. Marketing believes that this complimentary product will actually help the sales of OxyAlert and prevent the full adoption of your competitor’s product, TotalDiagnostic, in the marketplace. Market share for OxyAlert is projected to slightly increase by 1.5 percent over the next 5 years. Your finance team believes that this will provide an additional $50,000 of cash flow per year in this five-year time period. While this product will help the sales of OxyAlert, it will be sold separately. Revenue projections for DiagnosticSolutions will be $4 million in the first year of sales. Since this is already a fairly saturated market, the sales of DiagnosticSolutions are projected to increase by only 2% per year over the next five years. As this is a complimentary product, the development cost is nominal. You will, however, need to expand your assembly line with more specialized equipment. This will require an additional $6 million of capital. Since this equipment is custom made it tends to have a longer life than the equipment used for the other products under consideration. Typically the economic useful life of this equipment is 7 years. Your incremental cost of goods sold and SG&A expense will be in line with current company margins of 50% and 10% respectively. Projected working capital is 12% of revenue. Given that this is a complimentary product, you will not incur any additional one time marketing expenses for launching this product.

Decisions

As the year progresses, investors and creditors are getting nervous that your company cannot maintain its leadership position within the industry. They still believe in your management team and your company’s ability to produce innovative products. As a result you have the ability to access up to $30 million dollars from your financiers. Your creditors are willing to loan you money at a 6% interest rate, while your investors expect a return of 12% on their equity. Based on the required returns on equity and debt, the company’s weighted average cost of capital is 9.45%. On all projects, assume a 30% tax rate on income.  With good financial backing you have some important decisions to make in regards to these product launches. Again, your assignment is to make a recommendation on what new products to launch and provide an analysis on each product’s projected cash flow over a 5-year period.  In order to support your recommendation, you will need to integrate the principles of capital budgeting decision-making in your analysis.

Answer 1

Year	cumulative disc factor	OxyAlert II	Auto Analtytics	Dignostic Solutions
0	1.000	(20.00)	(10.00)	(6.00)
1	0.913	6.21	3.51	1.39
2	0.834	4.90	2.17	1.41
3	0.762	5.27	2.27	1.46
4	0.696	5.67	2.39	1.52
5	0.635	6.12	2.52	3.30
Present value		1.60	0.01	0.71 Year cumulative disc factor Particulars OxyAlert II Auto Analtytics Dignostic Solutions 0                          1.000 Initial investment         (20.00)                   (10.00)                              (6.00) 1                          0.913 Cash flow after tax              6.21                        3.51                                1.39 2                          0.834 Cash flow after tax              4.90                        2.17                                1.41 3                          0.762 Cash flow after tax              5.27                        2.27                                1.46 4                          0.696 Cash flow after tax              5.67                        2.39                                1.52 5                          0.635 Cash flow after tax              6.12                        2.52                                3.30 Present value              1.60                        0.01                                0.71Notes: 1. Expenses incurred before the start of project are sunk cost. Ths same should be ignored. 2. Calculation of Diagnostic Solutions (DS) also includes incremental revenue from Oxyalert of 0.05M (1-.3) = 0.035M in all the years 3. Straight line method of depreciation has been used in all cases. 4. In year 5 of DS, book value of equipment has been considered as sale value of equipment (i.e. 6/7*2). The management should invest in OxyAlert II and Diagnostics Solution as they generate highest NPV.