Reflector Medical Technology Inc. has incurred expenditure of K$5\mathrm{.}25$ million over the past

three years researching 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 K$100,000$ a year. The business would have to purchase plant

and equipment costing K$9$ million and invest K$3$ million in working capital immediately

for production to begin. A market research report, for which the business paid

K$61,000,$ indicates that the new product has an expected life of five years. Sales of

the product during this period are predicted as follows:

Year $1$ Year $2$ Year $3$ Year $4$ Year $5$

Number of units $(000$s$)8001,4001,8001,200500$

The selling price per unit will be K$30$ in the first year but will fall to K$22$ in the following

three years. In the final year of the product$$s life, the selling price will fall to K$20.$ Variable

production costs are predicted to be K$14$ a unit, and fixed production costs $($including

depreciation$)$ will be K$2\mathrm{.}4$ million a year. Marketing costs will be K$2$ 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 K$1$ million. The

business has a minimum expected rate of return by investors of $12\%$ a year.

$2|$ P a g e

$2.$ Reflector Medical Technology Inc. could agree to another business manufacturing and

marketing the product under license. A multinational business, AGAWA Plc$,$ has

offered to undertake the manufacture and marketing of the product, and in return will

make a royalty payment to Reflector Medical Technology Inc. of K$5$ per unit. It has

been estimated that the annual number of sales of the hearing aid will be $10\%$ higher

if the multinational business, rather than if Reflector Medical Technology Inc.,

manufactures and markets the product.

$3.$ Reflector Medical Technology Inc. could sell the patent rights to AGAWA Plc for K$24$

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 AGAWA

Plc the exclusive right to manufacture and market the new product.

Ignore taxation.

Required:

a$)$ Calculate the Accounting Rate of Return $($ARR$)$ and Payback period for option $1$

and advise whether the project is worthwhile. Assume the company has a target

ARR of $25\%$ and payback period of $2\mathrm{.}5$ years.

b$)$ Calculate the net present value and internal rate of return of each of the options

available to Reflector Medical Technology Inc.

c$)$ Identify and discuss any other factors that Reflector Medical Technology Inc.

should consider before arriving at a final decision.

d$)$ Recommend with reasons what you consider to be the most suitable option.