The engine is air breathing up to mach 5.5, it can do this because of a) it's novel pre-cooler design, and b) because unlike other air breathing designs, it doesn't liquefy the oxygen before using it as fuel, it 'merely' takes it to it's vapour point.
After mach 5.5 it operates as a relatively standard rocket engine up to orbital velocity (~mach 25) but by that point it's high enough that it doesn't have to fight through the thick air near the earth's surface so saves a lot of fuel. This increases the percentage of launch weight that can be used for payload.
This is worth funding above supersonic cars because it is as challenging an engineering project but it has a useful purpose: It aims to commoditize access to space by providing cheaper re-usable access to LEO.
It's also step towards the containerization of space (the introduction of standardized shipping containers made a huge difference to international trade).
p.s. I've been to their office, if that's where their budget's going they got a bad deal on the place.
The funding is primarily intended to enable them to build and test some of the more novel parts of their sabre engine. For example the pre-cooler design which is necessary to cool the air prior to its use as fuel will be tested in front of a jet engine.
From the press release - http://www.reactionengines.co.uk/pr_19_feb_09.html
"The demonstration programme will look at three key areas in the engine.
The first area, conducted by REL, concerns the revolutionary precooler that cools the incoming air as it enters the engine. During the programme a test precooler will be constructed using the actual module design for the flight engines. This will be tested on the companyâ(TM)s B9 jet engine experimental facility at Culham in Oxfordshire.
The second area is the cooling of the combustion chamber, where the propellants are mixed and burnt producing water vapour at around 3,000oC. The SABRE engine uses the air or liquid oxygen as the cooling fluid â" a key and unusual design feature as most rocket engines use the hydrogen fuel for cooling instead. EADS Astrium and DLR in Germany will be conducting this work using demonstration chambers fired at the DLR Lampoldhausen facility.
The third area, led by the University of Bristol, will explore advanced exhaust nozzles that can adapt to the ambient atmospheric pressure. This follows on from the successful STERN (Static Test of ED Rocket Nozzle) test rocket programme that was conducted last year. As part of the ESA contract a new water cooled chamber will be constructed and test fired."
You're correct, it's not much money for a space plane but it's a good step forward in establishing the viability of the engines.
A friend of mine works on the heat exchange system for the SABRE engines that will power Skylon. The SABRE engines are air breathing i.e. they use air they pick up on the way as fuel, hence they need less fuel at launch.
From their website: "The Sabre engine is essentially a closed cycle rocket engine with an additional precooled turbo-compressor to provide a high pressure air supply to the combustion chamber. This allows operation from zero forward speed on the runway and up to Mach 5.5 in air breathing mode during ascent. As the air density falls with altitude the engine eventually switches to a pure rocket propelling Skylon to orbital velocity (around Mach 25)."
More info here: http://www.reactionengines.co.uk/sabre.html
The engine saves weight by using the same combustion chamber during both modes of operation and in air breathing mode it only cools the oxygen to it's vapour point (as opposed to full liquidization) which greatly simplifies the engine design.
At least that's my understanding, IANARS.