Newton Electronics Ltd has incurred expenditure of 5m over the past three years research- ing and developing a miniature hearing aid. The hearing aid is now fully developed, and the directors are considering which of three mutually exclusive options should be taken to exploit the potential of the new product. The options are as follows: 1 The business 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. The business would have to purchase plant and equipment costing 9m and invest 3m 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 pre- dicted as follows: Predicted sales for the year ended 30 November Number of units (000s) Year 1 800 Year 2 1,400 Year 3 1,800 Year 4 1,200 Year 5 500 The selling price per unit will be 30 in the first year but will fall to 22 in the following three years. In the final year of the product's life, the selling price will fall to 20. Variable produc- tion costs are predicted to be 14 a unit, and fixed production costs (including depreciation) will be 2.4m a year. Marketing costs will be 2m a year. The business 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 1m. 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 if Newton Electronics Ltd, manufactures and markets the product. 3 Newton Electronics Ltd could sell the patent rights to Faraday Electricals plc for 24m, 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.

Ignore taxation.
8.5 296 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS 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.AppendixLO1