gour Pharmaceuticals Ltd. is considering investing in a new production line for its pain-reliever medicine for individuals who suffer from cardio vascular diseases. The company has to invest in equipment which costs $2,500,000 and will be depreciated under the MACRS system for a 5-year asset class. It is expected to have a scrap value of $700,000 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 account payable by $50,000 at the beginning of the project. Vigour Pharmaceuticals expect 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 Develop
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Vigour Pharmaceuticals Ltd. is considering investing in a new
production line for its pain-reliever medicine for individuals who
suffer from cardio vascular diseases. The company has to invest in
equipment which costs $2,500,000 and will be
MACRS system for a 5-year asset class. It is expected to have a scrap
value of $700,000 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 account payable by
$50,000 at the beginning of the project. Vigour Pharmaceuticals expect
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
pain-reliever. Expected annual sales for the product in the first
three years are $600,000 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 pain reliever will cause a net
decrease of $50,000 in profit contribution due to a decrease in sales
of the other lines of pain relievers produced by the company. By
investing in the new product line Vigour Pharmaceuticals would have
to use a packaging machine which the company already has. It is fully
depreciated and could be sold at the end of the project for $350,000
after-tax in the equipment market.
The company’s financial analyst has advised Vigour Pharmaceuticals to
use the weighted average cost of capital as the appropriate discount
rate to evaluate the project. The following information about the
company’s sources of financing is provided below:
a. 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.
b. Vigour Pharmaceuticals has also issued 4,000 new bond issues
with an 8 percent coupon, paid semi-annually and matures in 10
years. The bonds were sold at par, and incurred floatation cost
of 2 percent per issue.
c. The company’s
percent and is currently selling for $60, and there are 100,000
shares outstanding.
d. There are 300,000 shares of common
stock outstanding, and they are currently selling for $21 each.
The beta on these shares is 0.95.
Other relevant information is as follows:
i. 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.
ii. Vigour Pharmaceuticals has a marginal tax rate of 35 percent. In
the event of a negative taxable income, the tax is computed as
usual and is reported as a negative number, indicating a
reduction in loss after tax.
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.
1. Determine the weighted average cost of capital (WACC) for Vigour
Pharmaceuticals.
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