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seek further approval after that time, the companies experience with other diagnostic tests is that it is likely to be superseded by a new test by the end of the initial five years.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.
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.
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?