In: Accounting
Following the outbreak of the Novel Coronavirus (COVID 19), CPC a
pharmaceutical company is considering introducing a new vaccine
unto the market to help fight the virus. This will require the
injection of huge capital to the tune of GH¢40,000,000 for the
purchase of the equipment for production. It will cost CPC an
additional GH¢ 5,500,000 to set up the production facility and
install that equipment for production. Mr. Smart, the CEO of CPC
believes that the vaccine could be manufactured in a building owned
by the firm and located in East Legon. This vacant building and the
land can be sold for GH¢ 1,500,000 after taxes. CPC will finance
the production of the vaccine (including initial working capital
investment) by issuing 2000,000 new common stocks at GH¢ 20 per
share from its existing shareholders. A total of GH¢ 15,000,000 is
expected to be raised from the rights issue. It expects to finance
the remaining from the issue of a 5-year bond with a before-tax
yield to maturity (YTM) of 12%. Mr. Qwesi, the Finance Director has
estimated the beta of the project to be 2.5 and the average return
for stocks traded on the Ghana Stock Exchange to be 10% while the
rate on Government of Ghana traded Treasury bills is 5%. The
successful production of the vaccine will generate additional cash
flows for CPC. The Production and Marketing department has
presented the information in the table below:
Again the following information should be taken note of:
Feasibility studies cost the company GH¢2,000,000
Test marketing expenses amounts to GH¢1,000,000
The research into the discovery of the vaccine costs
GH¢5,000,000
Variable cost will increase by 5% per annum
Selling price will increase by 10% per annum
Marketing expense will be 5% of sales revenue per year
Overhead cost will be fixed at GH¢6000,000 per year
The project will last for five (5) years (2021-2025)
2020
Variable cost per unit of the product
GH¢150
Selling price per unit
GH¢350
Quantity
400,000units perannum
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Charge depreciation using the straight-line method
Salvage value for equipment is GH¢2,000,000
CPC falls within the 25% tax bracket
An initial working capital investment of GH¢10,000,000 will be
made. Subsequently,
net working capital at the end of each year will be equal to 10
percent of sales for that year. In the final year of the project,
net working capital will decline to zero as the project is wound
down. In other words, the investment in working capital is to be
completely recovered by the end of the project’s life
The introduction of this new vaccine is expected to lead to
10,000 units per annum drop in sales of vaccines for other types of
corona virus by. The selling price per unit of existing products is
GH¢100 while the variable cost is GH¢70. This has no tax
implications for the new vaccine.
The project will be financed with debt and equity
Re quire d:
a. Evaluate the project using the NPV and Profitability index and
recommend whether CPC should go ahead with the production of the
vaccine.
b. Discuss three (3) qualitative factors that the Management of CPC
might have to consider and how these factors are expected to
influence the decision of Management with regards to the production
of the vaccine.
c. Under what circumstances will you prefer profitability index to
NPV as project evaluation techniques.
d. Explain why sunk costs should not be included in a capital
budgeting analysis, but
opportunity costs and externalities should