Question

Healthy Options is a Pharmaceutical Company which is considering investing in a new production line
of portable electrocardiogram (ECG) machines for its clients who suffer from cardiovascular diseases.
The company has to invest in equipment which costs $2,500,000 and falls within a MARCS
depreciation of 5 years, and is expected to have a scrap value of $200,000 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
accounts payable by $50,000 at the beginning of the project. Healthy Options expects 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 product line. Expected annual sales for the ECG machines
in years one to three are $1,200,000, 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 portable ECG machines will cause a net decrease of $50,000 in
profit contribution after taxes, due to a decrease in sales of the other lines of tester machines produced
by the company. By investing in the new product line Healthy Options would have to use a packaging
machine which the company already has and which will be sold at the end of the project for $350,000
after-tax in the equipment market.
The company’s financial analyst has advised Healthy Options to use the weighted average cost of
capital as the appropriate discount rate to evaluate the project. Information about the company’s sources
of financing is provided below:
• 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. Healthy Options has also issued 4,000 new bond
issues with an 8 percent coupon, paid semiannually, and which matures in 10 years. The bonds
were sold at par, and incurred floatation cost of 2 percent per issue.
• 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.
• There are 300,000 million shares of common stock outstanding, and they are currently selling
for $21 each. The beta on these shares is 0.95.
Other relevant information about the company follows:
The 20-year Treasury Bond rate is currently 4.5 percent and you have estimated market-risk premium
to be 6.75 percent using the returns on stocks and Treasury Bonds from 2010 to 2019. Healthy Options
has a marginal tax rate of 25 percent.
As a recent graduate of the UWIOC, The General Manager of the company has hired you to work
alongside the Financial Controller of the company to help determine whether the company should invest
in the new product line. He has provided you with the following questions to guide you in your
assessment of the project and to present your findings to the Company.

REQUIRED:
7. Determine the weighted average cost of capital (WACC) for Healthy Options.
8. Calculate the initial investment cash-flows.
9. Calculate the after-tax operating cash-flows.
10. Determine the tax on salvage value of the equipment, then show the terminal year cash-flows.

11. Identify three (3) relevant cash flows which were mentioned in the case and how they should
be treated in the capital budgeting decision.
12. Taking into consideration all the information given, determine the Net Present Value of the
project and advise the company on whether to invest in the new line of product.
(Use your answer to Q7 rounded to the nearest whole in the calculations of the other questions where
necessary.)

Answer 1

7) Formula for WACC = Cost of common stock * percentage of common stock + Cost of preferred stock * * percentage of preferred stock+ Cost of debt * * percentage of debt (1-tax rate)

a) Cost of common stock = Risk free rate of return + Beta * (Market rate of return - Risk free rate of return)

                                       = 4.5 + .95 * (6.75-4.5)

                                       = 4.5 + 2.14 = 6.64%

Total value of Common stock = 300000 * 21 = 6,300,000

Percentage of common stock = 6,300,000/14,300,000 = 44.06%

b) Cost of preferred stock = Diviend per share/ Net proceeds from issue

                                      = 4.5/60 = 7.5%

Total value of preferred stock = 100000 * 60 = 6,000,000

Percentage of preferred stock = 6,000,000/14,300,000 = 41.96%

c) Cost of debt = Interest expense*(1- tax rate)/ Total debt

                      = 120000 * (1-.25)/2000000 = 4.5%

Total value of debt = 2,000,000

Percentage of debt = 2,000,000/14,300,000 = 13.98%

Total value of capital = 6300000+6000000+2000000 = 14,300,000

So, WACC = 6.64% *44.06% + 7.5%*41.96% + 4.5%* 13.98% = 6.70%