CASE STUDY: Sitges Electronics
Sitges Electronics Ltd has incurred expenditure of £5 million over the past three yearsresearching 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 toexploit the potential of the new product.
The options are:1 The business could manufacture the hearing aid itself. This would be a new departure, sincethe business has so far concentrated on research and development projects. The businesswould have to purchase plant and equipment costing £9 million for production to begin.
A market research report indicates that the new product has an expected life of five years. Salesof the product during this period are predicted as:
Predicted sales for the year ended 30 NovemberYear 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
The business intends to depreciate the plant and equipment using the straight-line methodand based on an estimated residual value at the end of the five years of £1 million. Thebusiness has a cost of capital of 10 per cent a year.
2 Sitges Electronics Ltd could agree to another business manufacturing and marketing theproduct under licence. A multinational business, Faraday Electricals plc, has offered to undertakethe manufacture and marketing of the product. In return it will make a royalty payment to SitgesElectronics Ltd of £5 per unit. It has been estimated that the annual number of sales of thehearing aid will be 10 per cent higher if the multinational business, rather than Sitges ElectronicsLtd, manufactures and markets the product.
3 Sitges 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 thesecond at the end of two years. This option would give Faraday Electricals the exclusive right tomanufacture and market the new product.TASK 2:
• (a) Calculate the net present value of each of the options available to Sitges Electronics Ltd.(DISCOUNT FACTOR IS 10%)
• (b) Identify and discuss any other factors that Sitges Electronics Ltd should considerbefore arriving at a decision.
• (c) State, with reasons, what you consider to be the most suitable option. • (d) Suggest
how the information could be used to inform business decision making.
Year 1% DF 2% DF 5% DF 10%DF
15%DF
1 0.9901 0.9804 0.9524 0.9091 0.8696
2 0.9803 0.9612 0.9070 0.8264 0.7561
3 0.9706 0.9423 0.8638 0.7513 0.6575
4 0.9610 0.9238 0.8227 0.6830 0.5718
5 0.9512 0.9057 0.7835 0.6209 0.4972
6 0.9416 0.8879 0.7462 0.5645 0.4329
7 0.9320 0.8706 0.7107 0.5132 0.3773
8 0.9227 0.8537 0.6770 0.4665 0.3293
9 0.9132 0.8371 0.6450 0.4240 0.2874
10 0.9038 0.8209 0.6145 0.3855 0.2509