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:

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. 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:

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. In return it 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 £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 Faraday Electricals the exclusive right to manufacture and market the new product.

Required:

Ignoring taxation,

(a) Calculate the net present value (as at the beginning of 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, with reasons, what you consider to be the most suitable option.

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Year 1 800 Predicted sales for the year ended 30 November Year 2 Year 3 Year 4 1,400 1,800 1,200 Year 5 Number of units (000s) 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 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. 500