This description illustrates the basics of any opportunity: there is a gap betwe
ID: 1172801 • Letter: T
Question
This description illustrates the basics of any opportunity: there is a gap between the present value of inflows and outflows. John thinks his idea can generate retail revenues of $45 million over three years. John’s venture only collects $36 million of the $45 million, with the retailer getting $9 million. Motion Alert pays $18 million to the manufacturer, $6 million to the independent sales organization, and $4.8 million to the government for taxes, leaving $7.2 million for John. If I adjust these totals by discounting them back to the beginning at 10% per year, which is the cost of capital, I get this:
3-Year Total
(millions)
One way to see what is going on is to draw a chart that shows how the total present value pie gets allocated:
The size of the pie reflects the total amount customers are willing to pay (in present value terms) for John’s product ($15 million for three years, discounted at 10%). The slices represent the cost of acquiring resources from the retailer (for distribution), the manufacturer, the sales organization, and the government (as taxes). The remaining slice belongs to John – that is the value of his idea. He owns 100% of the stock but keeps 16% of the value pie ($6/$37.3) because he needs external resources.
1) How do you explain the relative size in the shares of value?
3-Year Total
(millions)
(millions) Total Value From Customer $45.0 $37.3 Retailer Margin $9.0 $7.5 Sales Organization $6.0 $5.0 Manufacturer $18.0 $14.9 Taxes $4.8 $4.0 Motion Alert (Osher) $7.2 $6.0 MOTION ALERT (OSHER) $6.0 RETAILER MARGIN $7.5 TAXES $4.0 SALES ORGANIZATION $5.0 MANUFACTURER $14.9 CUSTOMER PRESENT VALUE (MILLIONS)
Explanation / Answer
John's venture is the final distributor to the customers.The Motion alert has to make payment to various retailers, manufacturers and sales organisation for puchase of goods and for making the goods saleable in the market. If Sales made by motion alert is $100 than the profits earned by the venture is $16. There is no connection in John owning 100% of the stock but he keeps only 16% of the share as the others are the normal operating costs in the business. There cannot be 100% share in the whole revenue as to make sales or products available they either have to be manufactured, purchase and there is cost involved in all these transactions. After removing all these costs from the revenue including government taxes will give the correct value of profit made by the venture.