Newton Electronics Limited
After three years of development, the company has finally been able to complete research on and development of the new hearing aid and the product, having successfully passed through all statutory and voluntary tests and procedures, is now ready for commercial production. In this regard, the company has three viable options in front of it. These are: 1. Commence commercial production on its own accord. 2. Outsourcing manufacturing and marketing to a third party under a license arrangement. 3. Selling Patent rights to a third party.
This reports aims to undertake a holistic financial analysis of these three options and, from a financial management perspective, conclude which option is in the best interests of the company’s shareholders. Results The results of the NPV analysis reveal the following results: Analysis, Additional Considerations & Verdict: The NPV analysis (see appendix) clearly reveals that Option 2 (allowing a third party to manufacture the product and market it under a license arrangement) is financially the best option as it allows for a greater inflow of cash.
This is also in line with the company’s core competencies. The company has been generally geared at research and development and may lack the entrepreneurial skill and expertise when it comes to manufacture and market the product. Moreover, another plus point is that the company would not have to pump in any capital immediately if it chose option 2. Thus, as rational investors, the company would prefer less risk per unit of return. When comparing option 2 with option 1, the company finds itself taking less risks and hence generating more returns.
The decision between option 2 and option 3 is a tricky one, although seemingly straightforward. With option 3, the company effectively shifts the whole element of operating risk on the third party, against a guaranteed payment in two equal installments. BPP states that “this reduces the return but also the risk, as financial management theory contends the return and risk relationship” (2007, pp. 95-98). From a financial risk management point of view, the only risk that the company is then exposed to is the default risk of the third party failing to make a timely payment of the second installment.
Here is where the interesting aspect comes in. Although default risk also exists with Option 2, that is, the third party would fail to make timely royalty payments, Rasheed states that “a licensing arrangement and an outright sale of the patent rights would differ legally as to what recourse the company would have in the case of default. ” (2009, pp. -54). From the surface of it, if the third party defaults under a license arrangement to pass on royalty payments, the company could always cancel the license or initiate penalizations on the third party by way of the licensing agreement.
Thus, the company can compel the third party, on its own accord, to resume payments or to offer something else in return, maybe an equity stake at attractive levels. However, a default on a sale would be a long drawn out legal battle that would increase the time frame of the proceeds being received altogether, incurring legal costs and making NPV fall. Thus, for the high return and low risk profile and the legal recourse that it offers, option 2 is the best option that the company should undertake.