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:

Variable cost per unit of the product Selling price per unit

Quantity

2020

GH¢150

GH¢350

400,000units perannum

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)

 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 be included.

Answer 1

Calculation of total finance needed:
Equipment cost	40000000
Installation & set up costs	5500000
Initial working capital(NWC 0)	10000000
Total capital needed	55500000
After-tax sale proceeds of land & bldg.	-1500000
Amt. that can be raised from new rights equity issue	-15000000
Balance to be raised thro'bonds	39000000

Cost of equity , ke, as per CAPM= RFR+(Beta*Market risk premium)

ie. RFR+(Beta*(Av. Mkt. return-RFR))

5%+(2.5*(10%-5%))=

17.5%

After-tax cost of bonds, kd =Before-tax yield*(1-Tax rate)

ie.12%*(1-25%)=

9%

so, now the WACC=(Wt.d*kd)+(wt.e*ke)

((39/(39+15))*9%)+((15/(39+15))*17.5%)=

11.36%

Year	0	1	2	3	4	5
1.Equipment cost	-40000000
2.Installation & set up costs	-5500000
NWC reqd.	10000000	15400000	16940000	18634000	20497400	0
3.Change in NWC	-10000000	-5400000	-1540000	-1694000	-1863400	20497400
4.After-tax salvage(2000000*(1-25%))						1500000
Operating cash flows:
5.Sales units p.a.		400000	400000	400000	400000	400000
6.Selling price/unit		385	423.5	465.85	512.435	563.6785
7.Total sales $(5*6)		154000000	169400000	186340000	204974000	225471400
8.Varible cost/unit		-157.5	-165.375	-173.64375	-182.32594	-191.44223
9.Variable cost $(5*8)		-63000000	-66150000	-69457500	-72930375	-76576894
10.Mktg. exp.(sales $ *5%)		-7700000	-8470000	-9317000	-10248700	-11273570
11.OH costs		-6000000	-6000000	-6000000	-6000000	-6000000
12.Depn.(45500000-2000000)/5		-8700000	-8700000	-8700000	-8700000	-8700000
13.EBIT(7-sum(9 to 12)		68600000	80080000	92865500	107094925	122920936
14.Tax at 25%(13*25%)		-17150000	-20020000	-23216375	-26773731	-30730234
15.EAT (13+14)		51450000	60060000	69649125	80321193.8	92190702.2
16.Add back"depn.(Row 12)		8700000	8700000	8700000	8700000	8700000
17.Incremental Contribution loss-old vaccine(100-70)*10000		-300000	-300000	-300000	-300000	-300000
18.Operating cash flows(15=16+17)		59850000	68460000	78049125	88721193.8	100590702
19.Net annual FCFs(1+2+3+4+18)	-55500000	54450000	66920000	76355125	86857793.8	122588102
20.PV F at 11.36%(1/1.1136^Yr.n)	1	0.89799	0.80638	0.72412	0.65025	0.58392
21.PV at 11.36%(19*20)	-55500000	48895474.1	53963174	55290501	56479638	71581733.3
22. NPV(sum of row 21)	230710521
PI=1+(NPV/Initial Investment)
ie.1+(230710521/55500000)=
5.16

b. Three (3) qualitative factors that the Management of CPC might have to consider:

1.The suceess of the new vaccine , is treating the pandemic .

2. the accuracy of the demand rate forecasted

3. The advent or not of competitors' products for preventing /treating the current novel coona virus

all the above will dictate CPC's decision to produce more or less of this type of vaccine.

c.Circumstances when profitability index will be preferred to NPV as project evaluation techniques:

1. When there are more than one opportunity available --with different levels of initial investments, we need to compare the net return to the initial investment required--that is we do, 1+ NPV/Initial investment)

If the result is < 1, it is evident that NPV is negative--so the project may not be selected.

If it is >1, then that which is greater will be selected, depending upon the level of investment, affordable at that point of time.

d. Sunk costs are those costs that have already been incurred & nothing can be done now, to reverse that decision. They are past or historical costs, from which can only be evaluated.

In the given case,

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

are all sunk costs --though very necessary for the project--have all been incurred in the past.

where as,

Incremental Contribution lost due to loss of sales of old vaccine to the tune of 10000 units , ie.(100-70)*10000= 300000---- is a negative externality of the introdution of the new vaccine project , in that it cannibalises the sales revenue from the older vaccine & we consider the net revenues(ie. sales-costs), in the NPV calculations.

Similarly,projects have opportunity costs like the revenue from rental income might have to be foregone, in giving space to operate this project.So, that rental income sacrificed for the sake of this project, is counted as cost of this project , for NPV calculations.