QUESTION 1

VPharm (Pty) Ltd ('VPharm') is a manufacturer and supplier of a range of pharmaceutical products. The head office is based in Johannesburg and manufacturing plants are situated in Cape Town, Durban and Port Elizabeth. VPharm has expanded rapidly over the past five years through the acquisition of smaller pharmaceutical companies, which is why manufacturing plants are located in different cities.

The company manufactures tablets and capsules covering various therapeutic fields. Products are used as prescription treatments for respiratory, gastro-intestinal and cardiovascular ailments. VPharm also manufactures over-the-counter medicines that can be purchased without a prescription.

VPharm is currently negotiating a licence agreement with BSK plc, a major international pharmaceutical group, regarding the manufacture and distribution of their world leading antimalaria tablets. It is envisaged that VPharm will acquire the exclusive rights to manufacture and distribute the anti-malaria tablets of BSK plc in sub-Saharan Africa for a period of ten years. The licence period will commence when the production facility has been commissioned and is operational.

The company will have to build a new manufacturing facility to produce the anti-malaria tablets. The existing manufacturing plants are operating at more than 80% capacity and growth is expected in the existing product ranges. VPharm has decided that the new plant will be erected in Johannesburg and has prepared the following initial capital budget:

12
VPHARM (PTY) LTD
ANTI-MALARIA TABLET PLANT
CAPITAL BUDGET
Notes Year 0 Year 1 Year 2 Year 3 Year 4
R'000 R'000 R'000 R'000 R'000
Acquisition cost of licence 1 (8 000)
Plant and equipment 2 (10 000) (28 000)
Revenue
3
45 000
80 000
120 000
Raw material costs
(17 100)
(28 000) (42 000)
Factory overheads 4 (5 400) (7 800) (10 600)
Quality control overheads 5 (1 800) (1 890) (1 985)
Gross profit margin
20 700
42 310
65 415
Warehouse expenses
5 (2 100)
(2 205) (2 315)
Royalties 1 (3 375) (6 000) (9 000)
Rental of premises 6 (1 200) (1 296) (1 400) (1 512)
Sales and marketing
expenses
7 (2 250)
(4 000) (6 000)
Logistical expenses 8 (2 700) (2 800) (4 200)
Other indirect overheads 5 (6 200) (6 510) (6 835)
Allocated head office costs 9 (2 500) (2 750) (3 025)
Earnings before interest,
tax, depreciation and
amortisation
279
16 645 32 528
Working capital 10 (5 900) (4 700) (5 460)
Net cash flows (18 000) (29 200) (5 621) 11 945 27 068
Notes

1 The initial payment on signing the licence agreement with BSK plc is estimated to be R8 million. VPharm has approached the South African Revenue Service (SARS) for guidance regarding the tax allowance applicable to the licence agreement. The SARS have agreed to an allowance of 10% per annum (not to be pro rated) in terms of section 11(gC) of the Income Tax Act. The first allowance will be claimed in the first year of production (year 2). VPharm will pay a royalty of 7,5% of revenue in respect of antimalaria tablets produced and sold and SARS has indicated that it will permit a deduction of these royalties paid for income tax purposes.

2 VPharm is to engage an independent engineering company to build the manufacturing plant. It will take a year for the engineering firm to complete the order, assembly and installation of the manufacturing plant. VPharm will have to pay an upfront deposit of R10 million for the plant and equipment and the balance (R28 million) will be due once the plant has been installed and commissioned. The plant will have an expected useful life of ten years. After ten years, the plant could be decommissioned and sold piecemeal for an 13 estimated 10% of initial cost. Alternatively, the plant could be upgraded and used for the manufacture of other VPharm products.

VPharm has approached the SARS for guidance regarding the tax allowances applicable to the plant and equipment. The SARS has indicated that a section 12C allowance for manufacturing activities may be claimed on the following basis:

• 40% in the year that the plant is brought into use, and
• 20% will be deductible in each of the three subsequent years.

The current statutory normal tax rate for companies is 29%.

3 Revenue is expected to increase over time as VPharm increases its share of the market for anti-malaria tablets. After year 4 revenue growth is expected to be 10% per annum, which is the current average growth in the anti-malaria tablet market.

4 50% of factory overheads are variable in nature. Depreciation has not yet been calculated and as a result has not been included in factory overheads.

5 VPharm intends to have world-class quality control procedures in place to ensure that tablets are manufactured in accordance with BSK plc standards. Quality control costs, warehouse expenses and other indirect overheads will be fixed in nature and will not vary with production volumes.

6 The property on which the new manufacturing facility is to be erected is to be leased for a period of 11 years and rentals will escalate by 8% per annum. Negotiations with the landlord are nearing completion and VPharm expects to enter into a lease agreement as soon as the licence agreement with BSK plc has been finalised.

7 VPharm employs 150 sales representatives to market and sell the company's basket of products. These sales representatives are remunerated mainly through sales commission, at a rate of 5% of invoiced and banked revenue. These representatives will market antimalaria tablets to VPharm's existing customer base of private health care providers and pharmacists.

8 Distribution of finished products to customers is to be outsourced to an independent third party. VPharm has negotiated a variable fee arrangement with the third party of 3,5% of invoiced revenue subject to a minimum aggregate charge of R2,7 million per annum for services rendered.

9 Head office cost allocations relate to accounting and human resource functions performed on behalf of the anti-malaria division. It is estimated that it would cost the anti-malaria division R1,8 million in year 2 to provide these services in-house, and that the expense would increase by 5% per annum thereafter.

10 The annual incremental investment in working capital is expected to increase by 10% per annum from year 5 onwards.

11 VPharm forecasts that, for year 5 and thereafter -

• gross profit margins will be 55%; and
• warehouse expenses, other indirect overheads and allocated head office expenses will increase by 5% per annum.

12 For the purposes of the draft capital budget, it has been assumed that all cash flows occur at the end of the year. This is consistent with the normal policy of the company when evaluating potential new projects.

13 All cash flows are exclusive of VAT.

14 VPharm does not derive taxable income from any other source.

Cost of capital
VPharm has determined its cost of capital to be 15%. The company has no external borrowings at present and has sufficient cash resources to fund the acquisition of the anti-malaria tablet plant.

MBX Ltd

MBX Ltd is a distributor of pharmaceutical products in Southern Africa. The company has recently been awarded various tenders to supply anti-malaria tablets to government departments in South Africa, Botswana and Mozambique. MBX Ltd has approached VPharm to purchase its entire planned production for year 2 and 3 to fulfil its supply obligations. MBX Ltd has also offered to collect finished products from VPharm's warehouse at their own cost, and be responsible for distribution of products to their customers. VPharm planned to supply products to the private sector (pharmacists and private health care providers) and had not intended to target the public sector.

The board of directors of VPharm is considering the MBX Ltd proposal but is uncertain as to how to price the proposed order.

REQUIRED

(a) Calculate the net present value at year 0 of the expected cash flows associated with the acquisition of the anti-malaria plant and equipment and with the operation of the division, using a discount rate of 15%. (Use the present value factors supplied in the appendix to this paper or a financial pocket calculator.)

(b) Calculate the revenue required in year 3 to enable the anti-malaria division to break even in that year. Include non-cash flow items but exclude tax.

(c)

(i) Evaluate the minimum revenue that VPharm should derive from supplying MBX Ltd in years 2 and 3 in order to match the forecast profit contribution by the anti-malaria division.

(ii) In addition, identify and list other key issues that should be considered in pricing the MBX Ltd order.

(d) Identify and list the key risks facing VPharm in pursuing the anti-malaria project.