Reference no: EM132777269

Question - 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 the three mutually exclusive options should be taken to exploit the potential of the new product. The options are as follows:

Option 1 - Newton Electronics Ltd could manufacture the hearing aid itself. This would be a new departure, 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 production 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 predicted as follows:

Predicted Sales for the year ended 30 November

Year 1 Year 2 Year 3 Year 4 Year 5

Number of units (000's) 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 products life, the selling price will fall to € 20. Variable production costs are predicted to be € 14 per unit. Fixed production costs (including depreciation) will be € 2.4 million per year. Marketing costs will be € 2 million a year.

Newton Electronics Ltd intend to depreciate the plant and equipment using the straight line method based on an estimated residual value at the end of the five years of € 1 million. The business has a cost of capital of 10% a year.

Option 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 aids will be 10% higher if the multinational business, rather than Newton Electronics manufactures and market the product.

Option 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 plc the exclusive right to manufacture and market the new product.

Required -

a) Calculated the Net Present Value (as a 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?