Question

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:
2020
Variable cost per unit of the product
GH¢150
Selling price per unit
GH¢350
Quantity
400,000units per annum
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)
Examiner: Isaac Ofoeda Page 3
 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
Required:
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 be included.
(Total: 20 marks)

Answer 1