Question

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 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 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 3 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.

Answer 1

Vigour Pharmaceuticals is considering a new pain-reliever production line. With an equipment cost of $2.5 million, working capital changes, and annual sales projections, financial analysis is crucial. The company's financial analyst suggests using the weighted average cost of capital for project evaluation, considering a new secured loan at 6%.

To evaluate the financial viability of the new production line for pain-reliever medicine, we need to consider various financial aspects and calculate relevant metrics. Let's break down the information and perform the necessary calculations:

Investment and Depreciation:

Equipment cost: $2,500,000

Depreciation under MACRS for a 5-year asset class

Scrap value: $700,000

Working Capital Changes (at the beginning of the project):

Increase in cash and cash equivalents: $100,000

Increase in inventory: $30,000

Increase in accounts receivable: $250,000

Increase in accounts payable: -$50,000

Transportation and Installation:

Transportation and installation cost: $450,000

Research and Development:

Initial investment in R&D: -$75,000

Expected Annual Sales:

First three years: $600,000 each

Following two years: $850,000 each

Variable Costs of Production:

Years 1-3: $267,000 per year

Years 4-5: $375,000 per year

Fixed Overhead:

Fixed overhead per year: $180,000

Decrease in Profit Contribution:

Net decrease: -$50,000

Packaging Machine:

Salvage value of the packaging machine: $350,000 (after-tax)

Loan Information:

New loan amount: $2,000,000

Interest rate on the loan: 6%

Discount Rate (Weighted Average Cost of Capital - WACC):

Use the WACC as the appropriate discount rate for project evaluation.

After incorporating these details, a comprehensive financial analysis, including net present value (NPV), internal rate of return (IRR), and payback period, can be conducted to assess the project's feasibility and make an informed investment decision.