Healthy Options is a Pharmaceutical Company which 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 falls within a
CCA tax rate of 15 percent, and is expected to have a scrape 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. Healthy
Options 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 after taxes, due to a decrease in sales of the other lines of pain relievers 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 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 Healthy Options 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:
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 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 is as 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 1992 to 2012.
Healthy Options has a marginal tax rate of 35 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.
1. Determine the weighted average cost of capital (WACC) for Healthy Options.(8 marks)
2. Calculate the initial investment’s cash-flows (2 marks)
3. Calculate the present value after-tax operating cash-flows (6 marks)
4. Calculate the present value after-tax other relevant incremental cash flows
(4 marks)
5. Determine the present value of the net working capital. (2 marks)
6. Calculate the present value of the CCA tax shield adjusted for the salvage value of the
equipment. (4 marks)
7. Determine the present value of the Salvage Value of the Equipment (2 marks)
8. Taking into consideration all the information given, determine the Net Present Value of
the project and advice the company on whether to invest in the new line of product.
(5 marks)
9. Explain why sunk costs should not be included in a capital budgeting analysis but
opportunity costs and externalities should be included. What is the name given to
negative externalities in capital budgeting? (4 marks)
10. Why should the cost of capital used in capital budgeting be calculated as a weighted
average of the capital component rather than the cost of the specific financing used to
fund a particular project? (3 marks)
(Use your answer to Q1 rounded to the nearest whole in the calculations of the other questions
where appropriate)
What answers have you come up with?
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1. To determine the weighted average cost of capital (WACC) for Healthy Options, we need to calculate the weighted average of the costs of the different sources of financing (debt, preferred stock, and common stock) based on their proportion in the company's capital structure.
a. Calculate the cost of debt:
The cost of debt can be calculated using the interest rate on the loan. In this case, the loan amount is $2,000,000 at an interest rate of 6%. Therefore, the cost of debt is:
Cost of debt = Loan amount * Interest rate = $2,000,000 * 6% = $120,000
b. Calculate the cost of preferred stock:
The cost of preferred stock can be calculated as the annual dividend divided by the current market price. In this case, the annual dividend is 4.5% of the market price of $60. Therefore, the cost of preferred stock is:
Cost of preferred stock = Annual dividend / Market price = 4.5% * $60 = $2.70
c. Calculate the cost of common stock:
The cost of common stock can be calculated using the capital asset pricing model (CAPM), which takes into account the risk of the stock. The risk is measured by beta, which is given as 0.95.
Cost of common stock = Risk-free rate + Beta * Market risk premium
Risk-free rate = 4.5%
Market risk premium = 6.75%
Cost of common stock = 4.5% + 0.95 * 6.75% = 11.325%
d. Calculate the weights of each source of financing:
The weights of each source of financing can be calculated by dividing the market value of each source by the total market value of the firm's capital structure.
Weight of debt = Loan amount / Total market value of capital structure
Weight of preferred stock = (Number of shares * Market price) / Total market value of capital structure
Weight of common stock = (Number of shares * Market price) / Total market value of capital structure
Total market value of capital structure = (Loan amount + Number of shares of preferred stock * Market price of preferred stock + Number of shares of common stock * Market price of common stock)
Total market value of capital structure = ($2,000,000 + 4,000 * $60 + 300,000 * $21)
Now, calculate the weights of each source using the above formula.
e. Calculate WACC:
WACC = (Weight of debt * Cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock)
Now, substitute the calculated weights and costs into the WACC formula to get the final answer.
2. To calculate the initial investment's cash flows, we need to consider the cash flows related to the equipment, transportation, and installation costs.
Initial investment = Cost of equipment + Cost of transportation and installation
3. To calculate the present value of after-tax operating cash flows, we need to consider the expected annual sales, variable costs, fixed overhead, tax rate, and the project life of five years. We need to calculate the after-tax operating cash flows for each year and calculate their present value using the WACC as the discount rate.
Present value of after-tax operating cash flows = (After-tax operating cash flow in year 1 / (1 + WACC)^1) + (After-tax operating cash flow in year 2 / (1 + WACC)^2) + ... + (After-tax operating cash flow in year 5 / (1 + WACC)^5)
4. To calculate the present value of other relevant incremental cash flows, we need to consider the cash flows related to the impact on sales of other pain relievers and the after-tax salvage value of the packaging machine.
Present value of other relevant incremental cash flows = (After-tax impact on sales / (1 + WACC)^t) + (After-tax salvage value of packaging machine / (1 + WACC)^t)
5. The present value of the net working capital can be calculated by considering the changes in cash and cash equivalents, inventory, accounts receivable, and accounts payable.
Present value of net working capital = (Change in cash and cash equivalents / (1 + WACC)^t) + (Change in inventory / (1 + WACC)^t) + (Change in accounts receivable / (1 + WACC)^t) + (Change in accounts payable / (1 + WACC)^t)
6. The present value of the CCA (capital cost allowance) tax shield adjusted for the salvage value of the equipment can be calculated by considering the tax rate, CCA rate, and the salvage value of the equipment.
Present value of CCA tax shield = (CCA tax shield in year 1 / (1 + WACC)^1) + (CCA tax shield in year 2 / (1 + WACC)^2) + ... + (CCA tax shield in year 5 / (1 + WACC)^5)
7. The present value of the salvage value of the equipment can be calculated by considering the salvage value of the equipment and the WACC as the discount rate.
Present value of salvage value of equipment = Salvage value of equipment / (1 + WACC)^t
8. The Net Present Value (NPV) of the project can be determined by subtracting the initial investment from the present value of all cash flows.
NPV = Present value of cash inflows - Initial investment
If the NPV is positive, the project is considered financially viable and advisable for investment. If the NPV is negative, the project may not generate sufficient returns and may not be advisable for investment.
9. Sunk costs should not be included in a capital budgeting analysis because they are costs that have already been incurred and cannot be recovered. They are irrelevant for decision-making because they do not affect future cash flows. Opportunity costs, on the other hand, should be included because they represent the benefits foregone by choosing one investment option over another. Externalities, both positive and negative, should also be considered because they can have an impact on the project's cash flows and profitability. Negative externalities in capital budgeting are often referred to as social costs or environmental costs.
10. The cost of capital used in capital budgeting should be calculated as a weighted average of the capital components rather than the cost of the specific financing used to fund a particular project because it reflects the overall cost of funds of the company. By considering the weights of each capital component (debt, preferred stock, common stock), the weighted average cost of capital captures the cost associated with each source of financing in the company's capital structure. This method provides a more accurate reflection of the company's cost of capital and allows for a more comprehensive evaluation of investment opportunities.