investment evaluation from a finance perspective

investment evaluation from a finance perspective

CASE STUDY IN FINANCE – Salza-Pharmaceuticals
Based in Australia Salza-Pharmaceuticals Company was formed in 1995 and is a leading manufacturer of a cholesterol busting drug known as Cholo-2®. The company’s founder Dr Zaide Salzman initially commenced his career with a large German pharmaceutical operator and eventually became CEO of a US listed health company. Dr Salzman moved away from the corporate sector to set up his own research house where he collaborated with researchers from CEU University in Perth Western Australia. After recently securing seed capital from investors Salza-Pharmaceutical Company intends to list on the Australian Stock Market in 2018. By 2013 Salza-Pharmaceuticals had signed a significant licencing deal with Aspel for the sales and marketing of Cholo-2®. A second licencing deal is in the pipeline with Aztor-Zanca after receipt of EU marketing clearance for a gel offering treatment and rapid relief for arthritis. As this arthritis gel is still in the early stages of commercial development Salza-Pharmaceuticals key cash flow direction is centred on the Cholo-2® drug. The company also produces a number of lines of health supplements and vitamins. By 2015, the company had a sales turnover of over $15 million with profits with excess of $3 million.
The company’s management recognises the licencing deal with Aspel as a potential company maker and as a result wishes to expand its Joondalup primary manufacturing facility. The new drug will cost more, but is superior to the primary competing product produced by its closest competitor. As a recent business school graduate working as a financial analyst at Salza-Pharmaceutical Company, you must analyse the project and present the findings to the company’s executive committee.
Production facilities for the Cholo-2® drug would be set up at the company’s main plant. A new high-tech production line facility will cost $1,225,000 inclusive of shipping and installation charges. This machine will have a useful life of 9 years, and can be depreciated on a straight-line basis. At the end of 9 years, the machine is expected to fetch a salvage value of $175,000. Due to heavy use, the new machine will have to be overhauled at the end of 5 years of its useful life, at a cost of $250,000. The cost of the overhaul can be further depreciated on a straight-line basis for the remainder of the machine’s life.
Management is being cautious and wary that the new product may not be as well received in the market as initially expected, and are concerned if it is advisable to commit funds to such a large capital expenditure. There is an alternative to buy a used production facility from Korea with a remaining useful life of 4 years for an installed cost of $575,000. The used machinery can also be depreciated on a straight-line basis but the firm expects it will not have any salvage value at the end of its useful life.
If the company goes ahead with this new production, expenditure of raw materials will have to be increased by $125,000 at the start of the first year. The supply contracts include consideration for the impact of inflation on raw material prices. Prices are expected to rise at a rate of 3% p.a. starting from the end of the first year.
Salza-Pharmaceuticals will utilise an unused section of its production plant for this project. The space has been unused for several years and consequently has suffered some deterioration. As part of a routine facility improvement program, the company spent $95,000 to rehabilitate that section of the plant last year. The company’s accountant, Mr Malcolm Smith believes this outlay which has already been paid for and expensed for tax purposes, should be charged toward the cholesterol drug project. He contends that if the rehabilitation had not taken place, the firm would have to spend the funds anyway to make the site suitable for the new project.
The company expects to sell 680,000 units of Cholo-2® each year at a price of $5.70 per unit. The new production will incur an additional $150,000 per annum in fixed costs. Variable costs are expected to be $2.50 per unit. The company will also set aside $45,000 at the start of each year for additional advertising and marketing expenses for this new product line. While examining the sales figures, you note a short memo from the company’s sales manager expressing concern that sales of Cholo-2® will cannibalise existing sales of other products which potentially complement Cholo-2®. Specifically, the sales manager estimates that the company can expect a reduction of $1.1 million in sales per year of their existing fish-oil capsule range of health drugs which they
FBL 5030 Fundamentals of Value Creation in Business Assignment 2 – Finance Page 4
manufacture at the same time. Reduced demand and production of the existing fish oil capsule range will decrease related production costs by $360,000. These revenue and cost projections are all expressed pre-tax.
Salza-Pharmaceuticals is a private company, soundly financed and consistently profitable. Cash on hand is insufficient to cover the capital expenditures. However, Mr Harvey is confident that part of the project’s cost can be financed with a new bank loan. The company has recently paid up a previous loan with a fixed rate of 10% p.a. Preliminary discussions with the company’s bank assures the company that it is in a position to secure a ten-year loan at a fixed rate of 7% p.a. with interest payable at the end of each year and the principal owing at maturity. The company’s tax rate is 30%.
At present, the company’s total assets on the balance sheet amount to $8 million. Because the previous bank loan has been fully paid off, the company’s equity value matches its asset value. Salza-Pharmaceutical shareholders have a 12% p.a. required rate of return for investing in the firm. If the Cholo-2® project is undertaken, the firm will borrow $2 million from the bank to fund existing operations. This added liability is expected to raise shareholders’ required rate of return to 15% p.a.
The executive committee requests a risk analysis on the project as they aim for profitability, but there are chances that it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, they concluded that the following variations on the original estimates should be considered:
• Unit sales at the end of the first year for the new Cholo-2® can rise by about +35% if market conditions are optimistic, or fall by about -35% if market conditions are pessimistic.
• Depending on consumer trends and competition, the firm can raise the $5.70 sale price by +25% (at the end of the first year) under optimistic estimates, or be forced to decrease the sale price by -25% under pessimistic estimates.
• The costs of raw materials which have an agricultural source are largely influenced by crop yields, and could vary by -30% p.a. and +30% p.a. from the start of the first year under optimistic and pessimistic conditions respectively.
• The salvage value of the new machine after 9 years of useful life is also uncertain. At best, the firm may be able to dispose of the asset for $150,000 but there is also a likelihood the firm cannot find a buyer for the machine at all.

After reviewing the data provided, you realise that the revenue and cost figures have not been adjusted for inflation which is expected to average 3.5% p.a. over the long term. Specifically, the sales price of $5.70 per unit is expected to increase at a rate of 3.5% p.a. by the end of the first year. Fixed, variable and marketing/ advertising costs for the new product are expected to increase at a rate of 2.5% p.a. from the initial cost estimates because these are largely fixed by contracts. The impact of cannibalisation is expected to be constant throughout the life of the project.
Your task as a financial analyst is to prepare an investment proposal to Dr Salzman and the executive committee of Green-Pharmaceutical Company. Your proposal should indicate whether the firm should go ahead with the new product offering. You must also discuss which of the following alternatives is advisable.
• Option A: The company should purchase a new production line facility immediately or,
• Option B: The Company should purchase the used Korean production line facility first, then switch to a new production line facility at the end of 4 years. (Note: the capital costs are not affected by inflation)

You are also required to provide summaries of the risk analyses for sensitive variables and inform management of break-even sales volumes and prices. Your proposal should address the list of requirements below.
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Required:
1. Calculate the appropriate Weighted Average Cost of Capital (WACC) for the company if this project proceeds. Apply this rate as the project’s required rate of return.

2. Prepare the incremental cash flow tables for Options A and B. Assume revenue and cost estimates from paragraph 7. Include adjustments for inflation in your cash flow forecasts. Discuss if the following items should or should not be included in the incremental cash flow tables.
• Interest expenses on the $2 million loan;
• The $95,000 spent last year to rehabilitate the plant; and
• The reduction in sales of existing products and associated production costs.

3. Using the base-case scenarios, determine the NPVs and IRRs of this project. On the basis of these measures, should the project be undertaken and if so, which option is more beneficial to the firm?

4. Consider the impact of unequal lives for Options A and B. Does this change your recommendation in (3)?

5. Consider the sensitivities of the project’s value against variations to: unit sales, sale price per unit, costs of raw materials, and the salvage value. Advise management which two variables will need to be scrutinised carefully if the project is implemented.

6. Using the base-case scenarios for Options A and B, determine:
• how low sales volume will have to fall to,
• how low sales price will have to fall to, and
• how high variable costs will have to rise to;

before the project becomes unfeasible to the company. Discuss how this impacts your recommendation in (4).
7. Without any calculations, the company would also like you to start a preliminary discussion on whether the production line facility should be leased or purchased outright. Your discussion should consider the advantages and disadvantages of adopting an operating or finance lease for the machine. Address how a lease arrangement might change your analyses

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