- 20 Marks
Question
Kakraba Pharmaceuticals LTD is considering commercialising a herbal-based medicine for managing blood sugar levels.
The following information relates to Kakraba Pharmaceuticals:
i) Commercialising the medicine requires constructing a new production facility, which entails capital expenditures of GH¢120 million immediately and GH¢210 million in the first year. The capital expenditure qualifies for capital allowance at 30% on a reducing balance basis. It is also estimated that the company will invest GH¢45 million in additional net working capital at the end of the first year. The working capital will be fully utilised and therefore there will be no recovery.
ii) Commercial production and sale of the medicine will commence in the second year and continue forever. However, the finance team is working with a five-year forecast period and assuming a constant growth rate in cash flows for periods beyond the forecast years.
iii) For the first year of commercial production and sale (i.e. year 2 of the project), the finance team projects that sales will be 10 million units, the unit sales price will be GH¢100, the unit variable cost will be GH¢80, and the relevant fixed costs will be GH¢30 million.
iv) The finance team forecasts annual growth rates in the cash flow factors for the three years following the commencement of commercial production and sale (i.e., year 3 to year 5) as follows:
| Factor | Annual growth rate |
|---|---|
| Sales volume | 10% |
| Sales price per unit | 15% |
| Variable cost per unit | 12% |
| Total fixed cost | 10% |
v) Beyond the five-year forecast period, after-tax net cash flows from the project are expected to grow at 5% every year in perpetuity.
vi) The company’s corporate income tax rate is 25%. Assume taxes are payable at the end of the year in which the profit is made.
vii) The company’s required rate of return on this project is 28%.
Required:
a) Appraise the project’s viability based on Net Present Value.
b) Calculate the discounted payback period.
c) Explain to the directors of the company the following types of real options and the circumstances under which they may consider exercising them:
i) Option to delay/defer.
ii) Option to expand (i.e. scale up).
Answer
a) Viability of the project based on the net present value and the discounted payback period
Schedule of after-tax incremental cash flows for the project
| EOY | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| GH¢’ million | ||||||
| Investments: | ||||||
| Capital expenditure | (120.00) | (210.00) | ||||
| Net working capital | (45.00) | |||||
| Total investments | (120.00) | (255.00) | – | – | – | – |
| Operating cash flows: | ||||||
| Sales revenue | – | – | 1,000.00 | 1,265.00 | 1,600.23 | 2,024.32 |
| Variable cost | – | – | (800.00) | (985.60) | (1,214.26) | (1,495.97) |
| Fixed cost | – | – | (30.00) | (33.00) | (36.30) | (39.93) |
| Capital allowance | – | – | (99.00) | (69.30) | (48.51) | (33.96) |
| Before-tax NOI | – | – | 71.00 | 177.10 | 301.16 | 454.46 |
| Tax on NOI @ 25% | – | – | (17.75) | (44.28) | (75.29) | (113.62) |
| After-tax NOI | – | – | 53.25 | 132.83 | 225.87 | 340.85 |
| Add back capital allowance | – | – | 99.00 | 69.30 | 48.51 | 33.96 |
| After-tax NOCF | – | – | 152.25 | 202.13 | 274.38 | 374.80 |
Terminal cash flow:
Terminal value of the project
After-tax NCFs
(120.00)(255.00)152.25202.13274.382,085.87
Supporting Workings:
-
Sales Revenue:
| 0 | 1 | 2 | 3 | 4 | 5 | |
|---|---|---|---|---|---|---|
| Sales volume | 10.00 | 11.000 | 12.100 | 13.310 | ||
| Sales price per unit | 100.00 | 115.00 | 132.25 | 152.09 | ||
| Sales revenue (GH¢) | 1,000.00 | 1,265.00 | 1,600.23 | 2,024.32 |
-
Variable Cost:
| 0 | 1 | 2 | 3 | 4 | 5 | |
|---|---|---|---|---|---|---|
| Sales volume | 10.00 | 11.00 | 12.10 | 13.31 | ||
| Variable cost per unit | 80.00 | 89.60 | 100.35 | 112.39 | ||
| Total variable cost | 800.00 | 985.60 | 1,214.26 | 1,495.97 |
-
Capital Allowance:
| 0 | 1 | 2 | 3 | 4 | 5 | |
|---|---|---|---|---|---|---|
| Beginning value | – | 120.00 | 330.00 | 231.00 | 161.70 | 113.19 |
| Addition | 120.00 | 210.00 | ||||
| Depreciable value | 120.00 | 330.00 | 330.00 | 231.00 | 161.70 | 113.19 |
| Capital allowance @ 30% | (99.00) | (69.30) | (48.51) | (33.96) | ||
| Ending value | 120.00 | 330.00 | 231.00 | 161.70 | 113.19 | 79.23 |
-
Terminal value
TV0=NCFs(1+g)ke−g=374.80(1+5%)0.28−0.05=1,711
Appraise the project’s viability based on net present value:
| EOY | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| GH¢’ million | ||||||
| After-tax NCFs | (120.00) | (255.00) | 152.25 | 202.13 | 274.38 | 2,085.87 |
| DF @ 28% | 1.0000 | 0.7813 | 0.6104 | 0.4768 | 0.3725 | 0.2910 |
| PV @ 28% | (120.00) | (199.22) | 92.93 | 96.38 | 102.21 | 607.07 |
| NPV @ 28% | 579.37 |
Recommendation:
The positive NPV suggests that the implementation of the project will add value to the firm.
Thus, it should be accepted for implementation.
b) Appraisal of the project’s viability based on the discounted payback period
| EOY | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| GH¢’ million | ||||||
| PV @ 28% | (120.00) | (199.22) | 92.93 | 96.38 | 102.21 | 607.07 |
| Cumulative PV | (120.00) | (319.22) | (226.29) | (129.91) | (27.70) | 579.37 |
| Discounted payback period | 4.05 |
Period = Years before full recovery + Balance of investment to be recoveredDCF of the full recovery year
Period = 4 + 27.70607.07 = 4.05 years
Recommendation:
The initial investment will be recovered before the end of the project’s lifespan. Thus, it should be accepted for implementation.
c) Explanation of the given types of real options and the circumstances under which they may consider exercising them.
i) Option to delay/defer
This is the case where the company’s management has the flexibility or the right to delay the implementation of the project until any uncertainties surrounding the project’s success are cleared or better knowledge or skills are acquired to ensure the successful implementation of the project.
This option should be exercised when uncertainties surround the project’s success. For instance, if the directors foresee uncertainties about demand for the new herbal-based medicine, feasibility of the production technology, or regulatory clearance, they should consider waiting until the uncertainties are cleared to prevent avoidable losses and enhance the value of the project when implemented later.
ii) Option to expand (i.e., scale up)
This is where management can make more investments to expand capacity to meet increasing demand as the market grows or turns out to be bigger than anticipated.
This option should be exercised in situations where the market can grow, the investment can be made in phases (i.e., divisible), and expanding to leverage the market’s growth will enhance the project’s value. For instance, if the demand for the new herbal-based medicine can grow beyond what is currently projected when the early users attest to its effectiveness, the directors should consider implementing the project even as the NPV is low and expand later when demand grows to enhance its value.
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