Devonia (Laboratories) Ltd has recently carried out successful clinical trials on a new type of skin cream, which has been developed to reduce the effects of ageing. Research and development costs in relation to the new product amount to £160,000. In order to gauge the market potential of the new product, an independent firm of market research consultants was hired at a cost of £15,000. The market research report submitted by the consultants indicates that the skin cream is likely to have a product life of four years and could be sold to retail chemists and large department stores at a price of £20 per 100 ml container. For each of the four years of the new product's life sales demand has been estimated as follows:
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Number of 100 ml containers sold
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Probability of occurrence
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11,000
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0.3
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14,000
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0.6
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16,000
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0.1
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If the company decides to launch the new product, production can begin at once. The equipment necessary to make the product is already owned by the company and originally cost £150,000. At the end of the new product's life, it is estimated that the equipment could be sold for £35,000. If the company decides against launching the new product, the equipment will be sold immediately for £85,000 as it will be of no further use to the company.
The new skin cream will require two hours' labour for each 100 ml container produced. The cost of labour for the new product is £4.00 per hour. Additional workers will have to be recruited to produce the new product. At the end of the product's life the workers are unlikely to be offered further work with the company and redundancy costs of £10,000 are expected. The cost of the ingredients for each 100 ml container is £6.00. Additional overheads arising from the product are expected to be £15,000 p.a.
The new skin cream has attracted the interest of the company's competitors. If the company decides not to produce and sell the skin cream, it can sell the patent rights to a major competitor immediately for £125,000.
Devonia (Laboratories) Ltd has a cost of capital of 12 per cent. Ignore taxation.
Required
(a) Calculate the expected net present value (ENPV) of the new product.
(b) State, with reasons, whether or not Devonia (Laboratories) Ltd should launch the new product.
(c) Discuss the strengths and weaknesses of the expected net present value approach for making investment decisions.