XYZ plc provides engineering and consultancy services to the oil and gas industry.  Over the past few years, they have incurred expenditure of £1m researching and developing a new product, the "UniSensor" for which they have registered a patent.

UniSensor is a system which provides innovative wireless technology (as opposed to conventional cabling) to measure the pressure and temperature of oil and gas wells.

XYZ have conducted market research which has indicated that the new product has an expected life of 5 years. Predicted sales are as follows:

The company's board of directors wish to progress to the manufacture and sale of the UniSensor system and are considering the following proposals:

Operations Director's Proposal - "In-House"

XYZ will manufacture the UniSensor system themselves. XYZ have so far concentrated on providing engineering and consultancy services. Manufacturing would be a departure from current activity.

The selling price per unit will be £200,000. Variable production costs are expected to be £125,000 per unit and product specific fixed production costs (including depreciation) will be £800,000 per annum. Marketing costs are estimated to be £200,000 per annum.

Under this proposal they will have to purchase plant and equipment costing £4m. XYZ intend to depreciate the plant and equipment using the straight-line method and based on an estimated residual value of £500,000 at the end of 5 years.

Financial Director's Proposal - "Outsource"

Under this proposal XYZ will "out-source" the manufacturing and marketing of the UniSensor system under licence, but will retain the patent.

XL Technologies plc is a multinational business which already provides similar, more conventional products to the global market and they have offered to undertake the manufacture and marketing of the UniSensor system. 

With XL's presence, reputation and existing customer base, annual sales volumes are estimated to be 25% higher than if XYZ were to manufacture and market the system themselves. All costs would be borne by XL and they would retain any profits.

In return, XL Technologies plc will make a royalty payment to XYZ of £15,000 per unit sold.

Marketing Director's Proposal - "Sell Patent Rights"

Under this proposal XYZ will sell the patent rights to XL Technologies. This option would give XL the exclusive right to manufacture and market the UniSensor system.  XL have offered £2m for the patent and payment would be made in three instalments; £1m payable immediately and £500,000 payable at the end of year 1 and year 2.

Additional Information

The company has a current capitalisation of £20 million equity (annual dividend = 12%) and long term corporate debenture debt of £10m (annual post tax interest cost = 6%).  The company do not anticipate any further finance requirement in order to progress the Unisensor project.

Required

1. Prepare for the five years of the project calculations for the annual EBITDA (earnings before interest, taxation, depreciation and amortisation) and a breakeven analysis, assuming that the Operations Director's Proposal is progressed.

2. Prepare a capital investment appraisal analysis which includes a consideration of  the net present value (NPV) of each of the three proposals.

3. Prepare an analysis which considers the sensitivity of the capital investment decision to:

a. Project Life

b. Sales Volume (units sold)

c. Sales Price (unit price)

d. Royalty (payment per unit)

4. Using the calculations and analysis in parts 1-3 above together with any other information you consider relevant, prepare a short report for the senior management of Well Skilled PLC which recommends which of the three proposals to progress.