Question 4.SE.5: Newton Electronics Ltd has incurred expenditure of £5 millio...
Newton Electronics Ltd has incurred expenditure of £5 million over the past three years researching and developing a miniature hearing aid. The hearing aid is now fully developed. The directors are now considering which of three mutually exclusive options should be taken to exploit the potential of the new product. The options are as follows:
1 Newton Electronics Ltd could manufacture the hearing aid itself. This would be a new depar-ture, since the business has so far concentrated on research and development projects. However, the business has manufacturing space available that it currently rents to another business for £100,000 a year. Newton Electronics Ltd would have to purchase plant and equipment costing £9 million and invest £3 million in working capital immediately for produc-tion to begin.
A market research report, for which the business paid £50,000, indicates that the new product has an expected life of five years. Sales of the product during this period are pre-dicted as follows:
| Predicted sales for the year ended 30 November | |||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Number of units (000s) | 800 | 1,400 | 1,800 | 1,200 | 500 |
The selling price per unit will be £30 in the first year but will fall to £22 for the following three years. In the final year of the product’s life, the selling price will fall to £20. Variable production costs are predicted to be £14 a unit. Fixed production costs (including depreci-ation) will be £2.4 million a year. Marketing costs will be £2 million a year.
Newton Electronics Ltd intends to depreciate the plant and equipment using the straight-line method and based on an estimated residual value at the end of the five years of £1 mil-lion. The business has a cost of capital of 10 per cent a year.
2 Newton Electronics Ltd could agree to another business manufacturing and marketing the product under licence. A multinational business, Faraday Electricals plc, has offered to undertake the manufacture and marketing of the product and, in return, will make a royalty payment to Newton Electronics Ltd of £5 per unit. It has been estimated that the annual number of sales of the hearing aid will be 10 per cent higher if the multinational business, rather than Newton Electronics Ltd, manufactures and markets the product.
3 Newton Electronics Ltd could sell the patent rights to Faraday Electricals plc for £24 million, payable in two equal instalments. The first instalment would be payable immediately and the second at the end of two years. This option would give Faraday Electricals the exclusive right to manufacture and market the new product.
Required:
(a) Calculate the net present value (as at 1 January Year 1) of each of the options available to Newton Electronics Ltd.
(b) Identify and discuss any other factors that Newton Electronics Ltd should consider before arriving at a decision.
(c) State what you consider to be the most suitable option and why.
Ignore taxation.
Newton Electronics Ltd
(a) Option 1
| Year 0 £m |
Year 1 £m |
Year 2 £m |
Year 3 £m |
Year 4 £m |
Year 5 £m |
|
| Plant and equipment | (9.0) | 1.0 | ||||
| Sales revenue | 24.0 | 30.8 | 39.6 | 26.4 | 10.0 | |
| Variable cost | (11.2) | (19.6) | (25.2) | (16.8) | (7.0) | |
| Fixed cost (ex. dep’n) | (0.8) | (0.8) | (0.8) | (0.8) | (0.8) | |
| Working capital | (3.0) | 3.0 | ||||
| Marketing cost | \underline{ } | (2.0) | (2.0) | (2.0) | (2.0) | (2.0) |
| Opportunity cost | \underline{ } | \underline{(1.0) } | \underline{(1.0) } | \underline{(1.0) } | \underline{(1.0) } | \underline{(1.0) } |
| \underline{ (12.0 )} | \underline{9.9 } | \underline{ 8.3 } | \underline{ 11.5 } | \underline{ 6.7 } | \underline{ 4.1 } | |
| Discount factor 10% | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value | (12.0) | 9.0 | 6.9 | 8.6 | 4.6 | 2.5 |
| NPV | \underline{ 19.6 } |
Option 2
| Year 0 £m |
Year 1 £m |
Year 2 £m |
Year 3 £m |
Year 4 £m |
Year 5 £m |
|
| Royalties | \underline{ – } | \underline{4.4 } | \underline{ 7.7 } | \underline{ 9.9} | \underline{6.6 } | \underline{ 2.8 } |
| Discount factor 10% | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value | \underline{ – } | 4.0 | 6.4 | 7.4 | 4.5 | 1.7 |
| NPV | \underline{24.0 } |
Option 3
| Year 0 | Year 2 | |
| Instalments | 12.0 | 12.0 |
| Discount factor 10% | 1.000 | 0.826 |
| Present value | 12.0 | 9.9 |
| NPV | \underline{ 21.9 } |
(b) Before making a final decision, the board should consider the following factors:
(i) The long-term competitiveness of the business may be affected by the sale of the patents.
(ii) At present, the business is not involved in manufacturing and marketing products.
Would a change in direction be desirable?
(iii) The business will probably have to buy in the skills necessary to produce the prod-uct itself. This will involve cost, and problems could arise. Has this been taken into account?
(iv) How accurate are the forecasts made and how valid are the assumptions on which they are based?
(c) Option 2 has the highest NPV and is therefore the most attractive to shareholders.
However, the accuracy of the forecasts should be checked before a final decision is made.