Question

Section 2 - CASE ANALYSIS INSTRUCTIONS:

1. Read the case below carefully and answer ALL the questions which follow.

2. Your answers may be entered using a Microsoft Excel spreadsheet OR may be entered in a table format using Microsoft Word.

HEALTHY OPTIONS INC.

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 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. Calculation of WACC |

After-tax cost of loan, kl: |

Before-tax cost*(1-Tax Rate) |

ie.6%*(1-25%)= |

4.50% |

After-tax cost of bond, kd: |

Using the formula to find the present value,ie.current market Price of bonds, |

Price-Flotation costs=PV of its future cash flows=PV of all its future coupon cash flows+PV of face value to be received at maturity----both discounted at the effective cost of debt (which we need to find out) |

Net proceeds of the bond=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n) |

where, net proceeds =1000*(1-2%)= $ 980 |

Pmt.= The semi-annual coupon in $ , ie. 1000*8%/2= $ 40 |

r= the effective rate of interest or YTM --that we need to find----?? |

n= no.of coupon period still to maturity, ie.10 yrs. *2= 20 |

FV= face value=Par value = $ 1000 |

So, plugging in these values in the formula, |

980=(40*(1-(1+r)^-20)/r)+(1000/(1+r)^20) |

Solving for r, we get the semi-annual before-tax cost/Yield as |

4.1491% |

Now, the annual before-tax yield/cost= |

(1+4.1491% )^2-1= |

8.4704% |

so, the annual After-tax cost of the bond= |

Before-tax cost*(1-Tax Rate) |

8.4704%*(1-25%)= |

6.35% |

Cost of preferred stock, k ps : |

k ps=$ dividend/Current market price |

(100*4.5%)/60= |

7.50% |

Cost of equity,ke |

As per CAPM, ke=RFR+(Beta*Market Risk premium) |

ie.ke=4.5%+(0.95*6.75%)= |

10.91% |

Now, for the WACC, |

Type of capital | Market Value | Wt. to Total | Cost | Wt. *Cost | |

Secured Loan | 2000000 | 10.93% | 4.50% | 0.49% | |

Bonds | 4000*1000= | 4000000 | 21.86% | 6.35% | 1.39% |

Pref. stock | 100000*60= | 6000000 | 32.79% | 7.50% | 2.46% |

Common shares | 300000*21= | 6300000 | 34.43% | 10.91% | 3.76% |

Total | 18300000 | 100.00% |
WACC= |
8.09% |

8. Calculation of the initial investment cash-flows | |

Initial investment | -2500000 |

Transp. & Installation | -450000 |

1.Total capital investment | -2950000 |

Initial NWC reqd. | |

Cash | 100000 |

Inc. in inventory | -30000 |

Inc. in Acc. Rec. | -250000 |

Inc. in Acc. Pay. | 50000 |

2.Total NWC reqd. | -130000 |

3.Total initial investment cash-flows(1+2) | -3080000 |

9. Calculation of the after-tax operating cash-flows. | ||||||

Year | 0 | 1 | 2 | 3 | 4 | 5 |

Sales | 1200000 | 1200000 | 1200000 | 850000 | 850000 | |

Variable costs | -267000 | -267000 | -267000 | -375000 | -375000 | |

Fixed OH | -180000 | -180000 | -180000 | -180000 | -180000 | |

MACRS depn. | -590000 | -944000 | -566400 | -339840 | -339840 | |

EBIT | 163000 | -191000 | 186600 | -44840 | -44840 | |

Tax at 25% | -40750 | 47750 | -46650 | 11210 | 11210 | |

NOPAT | 122250 | -143250 | 139950 | -33630 | -33630 | |

Add back" depn | 590000 | 944000 | 566400 | 339840 | 339840 | |

Loss of sales of other lines | -50000 | -50000 | -50000 | -50000 | -50000 | |

Incremental OCF | 540000 | 894000 | 516400 | 289840 | 289840 |

10.Tax on salvage value of the equipment & terminal year cash-flows | |

Carrying value of eqpt. (2950000*5.76%) | 169920 |

scrap value | 200000 |

Gain on salvage | 30080 |

Tax on gain(30080*25%) | 7520 |

1.ATCF on sale of eqpt.(200000-7520) | 192480 |

2.ATCF on sale pf pkg. m/c | 350000 |

3.NWC restored | 130000 |

4.Total Terminal yr cash flows(1+2+3) | 672480 |

11. Relevant cash flows |

1. the company needs to increase its cash and cash equivalents by $100,000---- cash inflow to the project & hence added as year 0 cash ----decreases the intial investment--unlike other current assets(inventory & receivables) |

2.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---- decreases the incremental operating cash flow & hence relevant. |

3. 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----- produces incremental FCF to the project & hence relevant. |

12..NPV analysis | ||||||

Year | 0 | 1 | 2 | 3 | 4 | 5 |

Initial investment cash-flows | -3080000 | |||||

Incremental OCF | 0 | 540000 | 894000 | 516400 | 289840 | 289840 |

Terminal year cash-flows | 672480 | |||||

Total FCFs | -3080000 | 540000 | 894000 | 516400 | 289840 | 962320 |

PV F at 8.09%(1/1.0809^ yr.n | 1 | 0.92515 | 0.85591 | 0.79185 | 0.73258 | 0.67775 |

PV at 8.09%(FCF*PV F) | -3080000 | 499583.68 | 765185.1 | 408911.8375 | 212332.4 | 652216.7 |

Net present value(sum of PV row) | -541770 | |||||

NOT ADVISABLE to INVEST as the NPV of CASH flows is
NEGATIVE |
||||||

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