Pharmos

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UNIVERSITYOF THE WEST INDIES

MGMT2023 – Financial Management

TUTORIAL # 2 – Due 6 December 2020; 11:55 PM ECT (20% course marks)

1. Canada Golf Club (CGC) is considering three independent projects for July 2021 tournament. The

three projects are project A, project B and project C. Given the following cash flow information,

calculate the payback period for each. If CGC requires a 3-year payback before an investment

can be made, which project(s) would be accepted?

2. Cricket World Cup (CWC) is considering a project proposal which requires an initial investment

of $72,625 and it is expected to have net cash flows of $15,000 per year for 8 years. The firm

cash flows are discounted at a rate of 12 percent.

a. What is the project’s Net Present Value (NPV)? (Rounded to 2 decimal places)

b. What is the project’s discounted payback period? (Rounded to 2 decimal places)

3. Pharmos Incorporated is a Pharmaceutical Company which is considering investing in a new

production line of portable electrocardiogram (ECG) machines for its clients who suffer from

cardio vascular diseases. The company has to invest in equipment which cost $2,500,000 and falls

within a MARCS depreciation of 5-years, and is expected to have a scrape value of $200,000 at

the end of the project. Other than the equipment, the company needs to increase its cash and

cash equivalents by $100,000, increase the level of inventory by $30,000, increase accounts

receivable by $250,000 and increase account payable by $50,000 at the beginning of the project.

Pharmos Incorporated expect the project to have a life of five years. The company would have to

pay for transportation and installation of the equipment which has an invoice price of $450,000.

The company has already invested $75,000 in Research and Development and therefore expects

a positive impact on the demand for the new product line. Expected annual sales for the ECG

machines in the first three years are $1,200,000 and $850,000 in the following two years. The

variable costs of production are projected to be $267,000 per year in years one to three and

$375,000 in years four and five. Fixed overhead is $180,000 per year over the life of the project.

Year Project A ($) Project B ($) Project C ($)

0 (Investment) -1,000 -$10,000 -$5,000

1 600 4,000 2,000

2 300 3,000 1,000

3 200 2,000 2,000

4 100 2,000 1,000

5 500 4,000 2,000

The introduction of the new line of portable ECG machines will cause a net decrease of $50,000

each year in profit contribution after taxes, due to a decrease in sales of the other lines of tester

machines produced by the company. By investing in the new product line Pharmos Incorporated

would have to use a packaging machine which the company already has and will be sold at the

end of the project for $350,000 after-tax in the equipment market.

The company’s financial analyst has advised Pharmos Incorporated to use the weighted average

cost of capital as the appropriate discount rate to evaluate the project. The following information

about the company’s sources of financing is provided below:

 The company will contract a new loan in the sum of $2,000,000 that is secured by machinery and

the loan has an interest rate of 6 percent. Pharmos Incorporated has also issued 4,000 new bond

issues with an 8 percent coupon, paid semi-annually and matures in 10 years. The bonds were

sold at par, and incurred floatation cost of 2 percent per issue.

 The company’s preferred stock pays an annual dividend of 4.5 percent and is currently selling for

$60, and there are 100,000 shares outstanding.

 There are 300,000 shares of common stock outstanding, and they are currently selling for $21

each. The beta on these shares is 0.95.

Other relevant information about the company follows:

The 20-year Treasury Bond rate is currently 4.5 percent and you have estimated market-risk premium to

be 6.75 percent using the returns on stocks and Treasury bonds from 2010 to 2019. Pharmos Incorporated

has a marginal tax rate of 25 percent.

As a recent graduate of the UWIOC, The General Manager of the company has hired you to work alongside

the Financial Controller of the company to help determine whether the company should invest in the new

product line. He has provided you with the following questions to guide you in your assessment of the

project and to present your findings to the Company.

Required: Answer the following questions given the information above

a. Determine the initial outlay of the project.

b. Calculate the annual after-tax operating cash flow for Years 1 -5.

c. Determine the terminal year non-operating cash flow in year 5:

d. Taking into consideration all the information given, determine the Net Present Value of the

project and advice the company on whether to invest in the new line of product.

e. What is the estimated Internal Rate of Return (IRR) of the project?

f. Should the project be accepted based on the IRR?

g. Calculate to the following for Pharmos considering its tax rate of 25 percent.

i. Total Market Value for the Firm

ii. After-tax cost of Loan

iii. After-tax cost of Bonds

iv. Cost of Equity

v. Cost of Preferred Stock

vi. Weighted Average Cost of Capital (WACC)