Capital Budgeting

You have just been appointed to the newly created position financial analyst position with the Australian company, Samphore Pty Ltd, which manufactures an innovative medical diagnostic test for breast cancer. Although the company has its operations in Australia, it was recently sold to a private equity company based in the United States whose shareholders are unable to utilise the value of the Australian Dividend franking credits. The new owners of Samphore Pty Ltd have just appointed a recently retired eminent pharmacological researcher to the head of the company. Yesterday, you received the following memo from this new CEO.

MEMO

To:   Financial Analyst

From:     CEO

Subject: New Product

The capital projects committee, which I chair, will be meeting soon to consider an investment to produce a new diagnostic test for prostate cancer that has recently been approved by the Australian health authorities. Although the regulatory approval to sell the test is five years, with an option to seek further approval after that time, the companies experience with other diagnostic tests is that it is likely to be superseded by a new test by the end of the initial five years. The following information has been provided by the accounting division with input from production and marketing.

Cost of new plant and equipment           $7 900 000

Freight and installation costs              $100 000

Estimated sales pattern

Year       Number of units

1         70000

2         120000

3         140000

4         80000

5         60000

Sales price per unit $300/unit years 1 to 4; $260/unit in year 5

Cost of Sales      $180 per unit

Annual fixed costs $200000

Depreciation      prime-cost over 5 years with no salvage value

Working capital  There will be an initial investment of $100 000 just to get the project underway. After that, extra investment will be necessary to bring the total of working capital up to 10% of the years estimated sales. This means that the total working capital will decrease from year 4. The final amount of working capital will be liquated at the end of year 5.

I am also told that the discount rate to evaluate this type of new product is 22% p.a. before tax which with the governments proposed reduction of the corporate tax rate to 28%, would be 15% p.a. after tax.

Prepare a report for me that addresses the following issues; Calculations are to be shown as part of your answer where required

1. I have read that accounting profits are not the appropriate measure of project benefits. Therefore, in which way should we measure the annual payoffs from this project?

2. Do Annual profits have any role to play in the capital-budgeting process?

3. How should we allow for depreciation in making this capital investment?

4. What is the significance of the Australian Tax system for our company when it makes capital-budgeting decisions?

5. What is the amount of the initial outlay?

6. What is the relevant amount of profits and cash flows returned by the projects each year?

7. What is the terminal cash flow for this project?

8. Show a cash-flow diagram that summarises the project outlay and future benefits

9. Compute the project's NPV and explain what it signifies?

10.  Compute the projects IRR and explain what it signifies?

11.  Should we invest in the project? Why or why not?

Questions to be completed

Complete all parts of the Case Study in chapter.

Assume that if taxation is relevant to this question, any taxes due are payable in the same year as net earnings are made.

Relevant word limit guidelines and mark allocations are as follows:

Part 1: no more than 100 words for this part of the question - 4 marks

Part 2: no more than 75 words for this part of the question - 3 marks

Part 3: no more than 100 words for this part of the question - 3 marks

Note: This part of the question is asking for a brief explanation of the relevance, if any, of depreciation to the capital budgeting process, including how any calculations (where required) would be undertaken given the relevant information provided in the question.

Part 4: no more than 75 words for this part of the question - 3 marks

Part 5: 2 marks

Part 6: 8 marks

Part 7: 3 marks

Part 8: 3 marks

Part 9: no more than 50 words for this part of the question - 3 marks

Note: For this part of the question do not discuss a final accept / reject decision as this is requested in Part 11 of this question. Instead, relate the project's NPV to the information provided in the question.

Part 10: no more than 50 words for this part of the question - 2 marks

Note: For this part of the question do not discuss a final accept / reject decision as this is requested in Part 11 of this question. Instead, relate the project's IRR to the information provided in the question.

Part 11: no more than 25 words for this part of the question - 2 marks

Note: For this part of the question your response should be based on the answers prepared for Parts 9 and 10 of this question.