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
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 considering which of three mutually exclusive options should be taken to exploit the potential of the new product. The options are: 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. This space will not continue to be leased if the decision is not to manufacture. The business 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: Table 1 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 in 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 a unit. Fixed production costs (including depreciation) will be 2.4 million a year. Marketing costs will be 2 million 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 1 million. The business has a cost of capital of 10 per cent a year.
Required: (i) Derive the relevant annual cash flows from year 0 to year 5. (ii) Calculate the net present value using cost of capital rate of 10%.
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