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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
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.
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
What answers have you come up with?
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