Aero Manufacturing Company is working on a new version of its tried-and-true wind-powered water pump. For 15 years, the firm had manufactured replacement parts for older-style windmills used on farms and ranches throughout the U.S. Southwest. However, the old-style pumps required the use of rods and leather seals that would wear out over time and require servicing. When Aero's owners initiated the design of a new pumping process, they explored a number of possible designs and spent over $270,000 to fabricate and test the new design before perfecting the system that they are now ready to place into production and begin marketing. To manufacture the new pumps, Aero will have to spend $650,000 on new equipment plus $250,000 on advertising and promotion for the launch of the new product. These expenditures will take place at year-end 2016.
a. What is the relevant initial cost of the new pump product?
b. Aero's management expects to sell 2,000 of the new units per year for the next 15 years, and these units will produce free cash flow for Aero of $150,000 per year. Furthermore, the firm's management estimates that the equipment purchased initially will last for the full 15 years, at which time it will have no salvage value. If Aero uses a 10 percent rate of return to evaluate its investments, what is the NPV of the new pump investment?
c. Just as Aero's management was about to launch the new investment, the firm's owner got a call from the A1 Windmill Company from Cross-Plains, Nebraska, inquiring about the possible purchase of the product design patent. The caller suggested that his company would be interested in paying as much as $110,000 for the exclusive rights to the new technology. Aero would have to sign over all of its rights to the new design in return for the payment. How should this offer influence Aero's decision to initiate manufacturing the new pump design?