Vigour Pharmaceuticals Ltd. is considering investing in a new production line for its pain-reliever medicine for individuals who suffer from cardio vascular diseases. The company has to invest in equipment which costs $2,500,000 and will be depreciated under the MACRS system for a 5-year asset class. It is expected to have a scrap value of $700,000 at the end of the project. Other than the equipment, the company needs to increase its cash and cash equivalents by $100,000, increase the level of inventory by $30,000, increase accounts receivable by $250,000 and increase account payable by $50,000 at the beginning of the project. Vigour Pharmaceuticals expect the project to have a life of five years. The company would have to pay for transportation and installation of the equipment which has an invoice price of $450,000. The company has already invested $75,000 in Research and Development and therefore expects a positive impact on the demand for the new pain-reliever. Expected annual sales for the product in the first three years are $600,000 and $850,000 in the following two years. The variable costs of production are projected to be $267,000 per year in years one to three and $375,000 in years four and five. Fixed overhead is $180,000 per year over the life of the project. The introduction of the new line of pain reliever will cause a net decrease of $50,000 in profit contribution due to a decrease in sales of the other lines of pain relievers produced by the company. By investing in the new product line Vigour Pharmaceuticals would have to use a packaging machine which the company already has. It is fully depreciated and could be sold at the end of the project for $350,000 after-tax in the equipment market. The company’s financial analyst has advised Vigour Pharmaceuticals to use the weighted average cost of capital as the appropriate discount rate to evaluate the project. The following information about the company’s sources of financing is provided below: a. The company will contract a new loan in the sum of $2,000,000 that is secured by machinery and the loan has an interest rate of 6 percent. b. Vigour Pharmaceuticals has also issued 4,000 new bond issues with an 8 percent coupon, paid semi-annually and matures in 10 years. The bonds were sold at par, and incurred floatation cost of 2 percent per issue. c. The company’s preferred stock pays an annual dividend of 4.5 percent and is currently selling for $60, and there are 100,000 shares outstanding. d. There are 300,000 shares of common stock outstanding, and they are currently selling for $21 each. The beta on these shares is 0.95. Other relevant information is as follows: i. The 20-year Treasury Bond rate is currently 4.5 percent and you have estimated the market-risk premium to be 6.75 percent using the returns on stocks and Treasury bonds. ii. Vigour Pharmaceuticals has a marginal tax rate of 35 percent. In the event of a negative taxable income, the tax is computed as usual and is reported as a negative number, indicating a reduction in loss after tax. Questions 4. Calculate the terminal cash flow of the project. 5. Taking into consideration all the information given, determine the Net Present Value of the project and advice the company on whether to invest in the new line of products. 6. Why should the cost of capital used in capital budgeting be calculated as a weighted average of the capital component rather then the cost of the specific financing used to fund a particular project?
Vigour Pharmaceuticals Ltd. is considering investing in a new
production line for its pain-reliever medicine for individuals who
suffer from cardio vascular diseases. The company has to invest in
equipment which costs $2,500,000 and will be
MACRS system for a 5-year asset class. It is expected to have a scrap
value of $700,000 at the end of the project. Other than the equipment,
the company needs to increase its cash and cash equivalents by
$100,000, increase the level of inventory by $30,000, increase
accounts receivable by $250,000 and increase account payable by
$50,000 at the beginning of the project. Vigour Pharmaceuticals expect
the project to have a life of five years. The company would have to
pay for transportation and installation of the equipment which has an
invoice price of $450,000.
The company has already invested $75,000 in Research and Development
and therefore expects a positive impact on the demand for the new
pain-reliever. Expected annual sales for the product in the first
three years are $600,000 and $850,000 in the following two years. The
variable costs of production are projected to be $267,000 per year in
years one to three and $375,000 in years four and five. Fixed overhead
is $180,000 per year over the life of the project.
The introduction of the new line of pain reliever will cause a net
decrease of $50,000 in profit contribution due to a decrease in sales
of the other lines of pain relievers produced by the company. By
investing in the new product line Vigour Pharmaceuticals would have
to use a packaging machine which the company already has. It is fully
depreciated and could be sold at the end of the project for $350,000
after-tax in the equipment market.
The company’s financial analyst has advised Vigour Pharmaceuticals to
use the weighted average cost of capital as the appropriate discount rate to evaluate the project. The following information about the company’s sources of financing is provided below:
a. The company will contract a new loan in the sum of $2,000,000
that is secured by machinery and the loan has an interest rate
of 6 percent.
b. Vigour Pharmaceuticals has also issued 4,000 new bond issues
with an 8 percent coupon, paid semi-annually and matures in 10
years. The bonds were sold at par, and incurred floatation cost
of 2 percent per issue.
c. The company’s
percent and is currently selling for $60, and there are 100,000
shares outstanding.
d. There are 300,000 shares of common
stock outstanding, and they are currently selling for $21 each.
The beta on these shares is 0.95.
Other relevant information is as follows:
i. The 20-year Treasury Bond rate is currently 4.5 percent and you
have estimated the market-risk premium to be 6.75 percent using the
returns on stocks and Treasury bonds.
ii. Vigour Pharmaceuticals has a marginal tax rate of 35 percent. In
the event of a negative taxable income, the tax is computed as
usual and is reported as a negative number, indicating a
reduction in loss after tax.
Questions
4. Calculate the terminal cash flow of the project.
5. Taking into consideration all the information given, determine
the
whether to invest in the new line of products.
6. Why should the cost of capital used in capital budgeting be
calculated as a weighted average of the capital component rather
then the cost of the specific financing used to fund a particular
project?
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