Question

Plato Pharmaceuticals Ltd. has invested $150,000 to date in developing a new type of insect repellent. The repellent is now ready for production and sale, and the marketing manager estimates are found in the chart below.

Year	Bottles per year	Selling Price	Variable Cost
1	150,000	$6.00	$3.00
2	165,000	$6.00	$3.15
3	175,000	$6.95	$3.25
4	190,000	$6.95	$3.55
5	190,000	$7.95	$3.60
6	170,000	$7.95	$3.90

Fixed costs (excluding amortization) are expected to be $200,000 a year. The figure is made up of $160,000 additional fixed costs and $40,000 fixed costs relating to the existing business that will be apportioned to the new business.

In order to produce the repellent, machinery and equipment costing $520,000 will have to be purchased immediately. The estimated residual (salvage) value of this machinery and equipment in six years time is $100,000. The business calculates depreciation following CCA rules.

The business has a cost of capital of 12%. CCA 30% (50% rule applicable) of depreciation will be used, and taxes are paid at a rate of 40%.

Plato Pharmaceuticals Ltd. has invested $100,000 to date in developing a new type of insect repellent. The repellent is now ready for production and sale, and the marketing manager estimates that the product will sell 150,000 bottles a year over the next five years. The selling price of the insect repellent will be $6 a bottle and variable costs are estimated to be $3 a bottle. Fixed costs (excluding amortization) are expected to be $200,000 a year. The figure is made up of $160,000 additional fixed costs and $40,000 fixed costs relating to the existing business that will be apportioned to the new business.

In order to produce the repellent, machinery and equipment costing $520,000 will have to be purchased immediately. The estimated residual (salvage) value of this machinery and equipment in five years time is $100,000. The business calculates depreciation following CCA rules.

The business has a cost of capital of 12%. CCA 30% (50% rule applicable) of depreciation will be used, and taxes are paid at a rate of 40%.

Required:

1.Create a cash flow statement for the product for the next 6 years

2.Calculate the net present value of the product.

3.Perform a Payback analysis using NPV and one without using NPV

4.Calculate the internal rate of return for the product.

5.Undertake sensitivity analysis to show how much the following factors would have to change before the product ceased to be worthwhile.

The initial cost of machinery and equipment

Operating costs – Fixed

Operating costs - variable

Price per bottle of repellent

The residual value of the machinery and equipment

Answer 1

	Profit & Loss		0	1	2	3	4	5	6
	Revenue			900000	990000	1216250	1320500	1510500	1351500
	Variable Expenses			450000	519750	568750	674500	684000	663000
	Fixed Expenses			200000	200000	200000	200000	200000	200000
	Gross Profit			250000	270250	447500	446000	626500	488500
	Depreciation			78000	132600	92820	64974	45481.8	31837.26
	PBT			172000	137650	354680	381026	581018.2	456662.7
	Tax			68800	55060	141872	152410.4	232407.3	182665.1
	PAT			103200	82590	212808	228615.6	348610.9	273997.6
	Depreciation Calculation
	Cost of Eqpmt		520000
	Depreciation			78000	132600	92820	64974	45481.8	31837.26
1)	Cash Flow Statement		0	1	2	3	4	5	6
	Outflows
	Initial Investment for Developing New Insect Repellant		150000
	Machinery Purchase		520000						-100000
	Tax			68800	55060	141872	152410.4	232407.3	182665.1
	Total Outflows		670000	68800	55060	141872	152410.4	232407.3	82665.1
	Inflows
	PBT			172000	137650	354680	381026	581018.2	456662.7
	Add Depreciation			78000	132600	92820	64974	45481.8	31837.26
	Total Inflows			250000	270250	447500	446000	626500	488500
	Net Inflows		-670000	181200	215190	305628	293589.6	394092.7	405834.9
2)	NPV of the product (@ 12% discount factor)					4,43,467	$
3)	Payback Period = Period in which initial investment is recovered
	Gross Profit			250000	270250	447500	446000	626500	488500
	Tax			68800	55060	141872	152410.4	232407.3	182665.1
	Net Cash Inflows			181200	215190	305628	293589.6	394092.7	305834.9
	Cumulative Net cash Inflows			181200	396390	702018	995607.6	1389700	1695535
	Payback Calculation			0	0	2.895238656	2.895239	2.895239	2.895239
	Payback Period		2.89 years
4)	IRR Calculation
	Profit & Loss		0	1	2	3	4	5	6
	Revenue			900000	990000	1216250	1320500	1510500	1351500
	Variable Expenses			450000	519750	568750	674500	684000	663000
	Fixed Expenses			160000	160000	160000	160000	160000	160000
	Gross Profit			290000	310250	487500	486000	666500	528500
	Depreciation			78000	132600	92820	64974	45481.8	31837.26
	PBT			212000	177650	394680	421026	621018.2	496662.7
	Tax			84800	71060	157872	168410.4	248407.3	198665.1
	PAT			127200	106590	236808	252615.6	372610.9	297997.6
	Here fixed expenses are considered on incremental basis i.e. only additional fixed cost = 160000
	Cash Flow Statement		0	1	2	3	4	5	6
	Outflows
	Initial Investment for Developing New Insect Repellant		150000
	Machinery Purchase		520000						-100000
	Tax			84800	71060	157872	168410.4	248407.3	198665.1
	Total Outflows		670000	84800	71060	157872	168410.4	248407.3	98665.1
	Inflows
	PBT			212000	177650	394680	421026	621018.2	496662.7
	Add Depreciation			78000	132600	92820	64974	45481.8	31837.26
	Total Inflows			290000	310250	487500	486000	666500	528500
	Net Inflows		-670000	205200	239190	329628	317589.6	418092.7	429834.9
	IRR	35.5%