Bridge Link Limited (BLL), is a company involved in the business of research & development. The company has incurred expenditure of K4.5 million over the past three years researching and developing a special computer with artificial human intelligence. The computer is now fully developed, and the directors are considering which of two mutually exclusive options should be taken to exploit the potential of the new product. The directors think the completion of the project would now allow the company to hold on to cash after massive expenditure on research & development. The options are as follows:

OPTION ONE:

The option involves the company manufacturing the computer. This would be a new departure, since the company has so far concentrated successfully on research and development projects. However, the company has manufacturing space available that is currently idle. The company would have to purchase plant and equipment costing K200 million and invest K80 million in working capital immediately for production to begin. The working capital is expected to increase by 5% per year. A market research report, for which the business paid K80, 000, indicates that the new product has an expected life of five years. Sales of the product during this period are predicted as follows: YEAR 1 2 3 4 5 No.of Units (‘000) 8.4 13.5 19.6 13 7.2 The selling price per unit will be K25, 000 in the first two years but will fall to K20, 000 in the following two years. In the final year of the product’s life, the selling price will fall to K18, 000. Variable production costs are predicted to be 35% of the selling price, and fixed production costs (including depreciation) will be K60 million a year. Marketing costs will be K3 million per 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 K50 million. The project would be funded using 60% equity and the remainder 10% bond with five years maturity and par value of K1, 000. The bonds have a market value of K1, 030. The estimated project beta is 1.4. The equity premium is 8% and risk free rate of 4.5%. The annual tax rate is 30% payable in arrears of one year.

OPTION TWO:

BLL, could sell the patent rights to an American company AHN plc. For K190 million net of tax, payable in two equal installments. The first installment would be payable immediately and the second at the end of two years. This option would give AHN plc. The exclusive right to manufacture and market the new product. The company cost of capital is 10%.

a) Evaluate each of the two options available to BLL. and state the suitable one based on your financial evaluation.

b) Discuss any other factors that BLL. should consider before arriving at a decision.

c) Explain how the environmental uncertainty may impact the investment decision.