1. **Problem Statement:** Calculate the Net Present Value (NPV) for each of the three options available to Simtech Ltd. and advise on the best option. 2. **Formulas and Important Rules:** - NPV formula: $$NPV = \sum_{t=0}^n \frac{C_t}{(1+r)^t}$$ where $C_t$ is net cash flow at time $t$, $r$ is discount rate (10%), and $n$ is project life (5 years). - Depreciation (straight-line): $$\text{Depreciation} = \frac{\text{Cost} - \text{Residual value}}{\text{Life}}$$ - Opportunity cost of rented space is included as a cost. 3. **Option A: Manufacture the device** - Initial investment: Plant and equipment = 9 million, Working capital = 30 million (immediate outflow) - Depreciation per year: $$\frac{9 - 10}{5} = -0.2\text{ million (negative depreciation means residual value higher than cost, so depreciation is zero}$$ (Assuming no depreciation expense since residual > cost, or treat depreciation as zero) - Opportunity cost: 1 million per year - Market research cost (0.5 million) is sunk, ignore in NPV - Sales units (in thousands): 800, 1400, 1800, 1200, 500 - Selling prices: Year 1 = 300, Years 2-4 = 220, Year 5 = 200 - Variable cost per unit = 140 - Fixed production costs = 24 million/year (includes depreciation) - Marketing costs = 20 million/year Calculate annual revenues, variable costs, contribution, fixed costs, and net cash flows: Year 1: - Sales revenue = 800,000 units * 300 = 240 million - Variable cost = 800,000 * 140 = 112 million - Contribution = 240 - 112 = 128 million - Fixed + marketing + opportunity cost = 24 + 20 + 1 = 45 million - Net cash flow before tax = 128 - 45 = 83 million Year 2: - Sales revenue = 1,400,000 * 220 = 308 million - Variable cost = 1,400,000 * 140 = 196 million - Contribution = 308 - 196 = 112 million - Fixed + marketing + opportunity cost = 45 million - Net cash flow = 112 - 45 = 67 million Year 3: - Sales revenue = 1,800,000 * 220 = 396 million - Variable cost = 1,800,000 * 140 = 252 million - Contribution = 396 - 252 = 144 million - Net cash flow = 144 - 45 = 99 million Year 4: - Sales revenue = 1,200,000 * 220 = 264 million - Variable cost = 1,200,000 * 140 = 168 million - Contribution = 264 - 168 = 96 million - Net cash flow = 96 - 45 = 51 million Year 5: - Sales revenue = 500,000 * 200 = 100 million - Variable cost = 500,000 * 140 = 70 million - Contribution = 100 - 70 = 30 million - Net cash flow = 30 - 45 = -15 million Add recovery of working capital (30 million) at end of year 5. Calculate NPV: $$NPV_A = - (9 + 30) + \frac{83}{1.1} + \frac{67}{1.1^2} + \frac{99}{1.1^3} + \frac{51}{1.1^4} + \frac{-15 + 30}{1.1^5}$$ Calculate each term: - Initial = -39 million - Year 1 = 75.45 million - Year 2 = 55.37 million - Year 3 = 74.39 million - Year 4 = 34.82 million - Year 5 = $$\frac{15}{1.61051} = 9.31$$ million Sum: $$NPV_A = -39 + 75.45 + 55.37 + 74.39 + 34.82 + 9.31 = 210.34\text{ million}$$ 4. **Option B: Royalty** - Sales increase by 10% over Option A units. - Units sold per year: 880, 1540, 1980, 1320, 550 (10% increase) - Royalty per unit = 50 - Annual royalty = units * 50 - Calculate NPV of royalty payments: Year 1: 880,000 * 50 = 44 million Year 2: 1540,000 * 50 = 77 million Year 3: 1980,000 * 50 = 99 million Year 4: 1320,000 * 50 = 66 million Year 5: 550,000 * 50 = 27.5 million NPV: $$NPV_B = \sum_{t=1}^5 \frac{-\text{Royalty}_t}{(1.1)^t}$$ Calculate: - Year 1: -40.00 million - Year 2: -63.64 million - Year 3: -74.39 million - Year 4: -45.10 million - Year 5: -17.07 million Sum: $$NPV_B = -240.20\text{ million}$$ 5. **Option C: Sell patent rights** - Receive 240 million in two equal instalments: 120 million now and 120 million in 2 years. - NPV: $$NPV_C = 120 + \frac{120}{(1.1)^2} = 120 + 99.17 = 219.17\text{ million}$$ 6. **Advice:** - Option C has highest NPV (219.17 million), followed by Option A (210.34 million), and Option B has negative NPV (-240.20 million). - Recommend Option C: sell patent rights. 7. **Other factors to consider:** - Strategic control: Option C loses control over product. - Long-term benefits: Option A may offer future growth and market presence.