Case Scenario:
The Cough Syrup Case:
Every fall, flu season hits the East Coast of the United States. The world-famous Giraffe Company is looking to set up a plant to produce a new type of cough medicine to compete with Pfizer’s Robitussin brand of cough syrup. The main complaint against Robitussin is that it is not potent enough to effectively suppress severe coughing. Not only does excessive coughing decrease productivity, it is also very annoying. The new product, called “Cough Cough No More!”, will be based on a new formula that has four times the potency of Robitussin without any of the side effects.
The plant is expected to last for 25 years. The initial cost is $65 million. This cost can be depreciated over 15 years using straight line depreciation. The salvage value of the plant equipment after 15 years is $3 million in real terms. After 15 years, the plant will be renovated in order to ensure that it can continue producing high quality medicine. The cost of the renovation will be $10 million in real terms and can be depreciated using straight line depreciation over the remaining 10 years of the plant’s life. The salvage value of the equipment in the plant after the remaining 10 years will be $2 million in real terms. The plant is to be built in West Philadelphia (near the Wharton campus), and the land could otherwise be rented out for $1.5 million a year in real terms for 25 years.
The plant can produce 10 million bottles of cough syrup per year. The price of a bottle of cough syrup is currently $3.50. Analysts expect that this price will grow at a rate of 5% per year in real terms for the first 5 years, then at 2% per year in real terms for the next 5 years, and finally at 0% per year in real terms thereafter for the remainder of the plant’s lifetime. The Giraffe Company expects to be able to sell all the cough syrup that it produces. The cost of ingredients and packaging for each bottle of cough syrup is currently $1 per bottle. These costs are expected to grow by 1% per year in real terms through the life of the project. The total labor costs of operating the plant are expected to be $5 million in nominal terms in the first year of production and this is expected to increase at 5% per year in real terms thereafter.
Economic forecasters believe the rate of inflation will be 3% per year over the lifetime of the plant. The firm’s total tax rate (including local taxes) is 35% per year. The firm has other profitable lines of business so it can offset any losses from the medicine plant for tax purposes. The opportunity cost of capital for this type of project is 10% per year in nominal terms. Today is date 0; all cash flows occur at the end of the year unless otherwise stated.
Instructions:
For all dollar values, please give your answer to the nearest $1000 dollars, unless explicitly stated otherwise. For example, if your answer is $390,213,924 please enter 390214. For percentages, please give your answer as a decimal to three decimal places. For example, if your answer is 11.22% please enter 0.112. We highly recommend you use a spreadsheet program such as Excel to solve this case, although it is possible to solve it without one.
Case Questions:
Question 1. What is the salvage value of the plant equipment after 15 years, in nominal terms?
Question 2. What is the value of the depreciation tax saving per year, in nominal terms, in the first 15 years?
Question 3. What is the cost of the renovation at the end of 15 years, in nominal terms? This is a cost (so negative cash flow), but please enter here as a positive number.
Question 4. What is the value of the depreciation tax savings per year, in nominal terms, in the last 10 years of the plant’s lifetime?
Question 5. What is the market (nominal) price of a bottle of cough syrup at the end of the 1st year of production?
Question 6. What is the revenue (price per bottle times bottles sold) in nominal terms, for the 10th year of production?
Question 7. What is the nominal value of total labor costs in the last (25th) year of production?
Question 8. What is the nominal value of the after-tax rental loss opportunity cost in year 25?
Question 9. What is the total nominal cash flow in year 15?
Question 10. What is the total nominal cash flow in year 25?
Question 11. What is the 15 year nominal discount factor?
Question 12. What is the 25 year nominal discount factor?
Question 13. What is the discounted cash flow (DCF) for year 15?
Question 14. What is the discounted cash flow (DCF) for year 25?
Question 15. What is the Net Present Value (NPV) of the project?
Question 16. Should the firm undertake the project?
Question 17. What is the IRR of this project, in nominal terms?
Question 18. The firm spent $20 million on an extensive market survey several years ago. How does this affect the NPV of the project?
Question 19. If the land that the plant is to be built on could be rented out for $6 million a year in real terms for 25 years, instead of $1.5 million, what is the NPV of the project?
Question 20. The firm has another opportunity to build a cookie plant instead of the cough syrup plant. The cookie plant project has an IRR of 55% and an NPV of $35 million. The two projects are mutually exclusive. Which project should the firm undertake?