Just wanted some clarification on this capital budgeting scenario

1) Would this be considered an expansion or replacement decision?

2) Because the building modification is tax deductible, would the deductible amount be 22500 and be deducted at time 0 (time of purchase)?

3) If it is a replacement scenario, how would I calculate incremental cash flows? Especially the cash flows of the current product.

Pelican Pharmaceuticals Ltd (PPL) is an Australian company that manufactures generic pharmaceutical products for supply to the Australian, New Zealand and Asian markets. The majority of the business is in Australia but both the other markets are growing rapidly but from a very low base. The company manufactures commonly used products that no longer have patent protection and the majority of their business comes from prescription products supplied under the Pharmaceutical Benefit Scheme (PBS) in Australia. The company does however conduct some limited research and development and has in recent years launched two differentiated products. These products are not listed PBS products but are sold over the counter (OTC) with limited medical claims. PPL has manufacturing premises that operate under the code of good manufacturing practice and is licensed to manufacture human pharmaceutical products for distribution in their three markets. They also undertake contract manufacturing for other companies. The business is successful and is listed on the ASX. Freddy Ferguson, the CEO of PPL, is very keen on launching a new OTC product for the treatment of constipation in adults as he believes the product has some unique features which will expand their business considerably, particularly in older age groups. The product is based on psyllium husk, a natural fibre product, well known in the pharmaceutical industry. The new product is a powder that can be mixed in water but is unique in that the mixture contains only natural products with no artificial flavours or colourings. Extensive testing has revealed that the side effects are considerably less than the products currently on the market. PPL currently markets a tablet that is based on a similar fibre but this product does have some side effects particularly in older people. The launch of this new product will require considerable capital expenditure as it will require new manufacturing equipment and some building modifications to accommodate the new equipment. The equipment will have spare capacity as PPL currently produce no other powder products. The matter is becoming urgent as Tom Carter, the Manufacturing Director, has just returned from India where he has identified a reliable source of psyllium husk and has negotiated an exclusive deal with an Indian partner. The agreement has yet to be signed but the Indian partner is anxious that the deal be finalised. Freddy recently called a meeting to discuss the project. In addition to Freddy and Tom the meeting was also attended by Jennifer Brown, Research and Quality Assurance Director, Miguel Sanchez, Sales and Marketing Director and Anna Chen, Financial Controller. Freddy and Miguel were very keen on the project and saw a great opportunity to increase sales, both in Australia and New Zealand, and had presented a sales forecast at the meeting. Tom was concerned that based on the sales figures presented the new equipment would only be working to about 50% of its capacity and the cost could not be justified. Jennifer pointed out that the research on the new product had cost $250,000 and PPL needed to launch the new product to justify this expenditure. Freddy added that in addition to this research expenditure Tom had been to Europe to investigate suitable mixing and packing machinery and that this trip had cost $30,000. His two trips to India had also cost $40,000 and legal expenses another $12,000. It was important that the project went ahead to recover these expenses. Tom had identified suitable machinery but was waiting for final quotes. The machinery was expected to cost approximately $1,000,000. A firm quote of $75,000 had already been received for the internal building modifications. Anna reminded the meeting that this level of expenditure would require board approval and that the Board required that the NPV and IRR for the project be calculated and an executive summary of the project be submitted to the Board together with the discounted cash flow calculations. Anna was concerned that the preliminary sales figures would not justify the expenditure and would like to see a higher usage of the equipment. Miguel undertook to investigate the possibility of more contract manufacturing to utilise the spare capacity. Freddy asked that all the attendees work together over the next two weeks to assemble all the data needed to obtain approval of this project and stated he believed this project is vital for the continued growth of the company. Two weeks later the management team met to discuss the data assembled for the project. Tom stated that he had received a firm quote of $1,050,000 for the new equipment. Tom and Miguel then presented the sales and cost data which is attached as Appendix 1. The forecast covered both the sales of the new product and sales of additional powder products manufactured for other companies (contract sales). The forecasts were only for five years because it was expected that sales and costs would only increase in line with the general rate of inflation in subsequent years. It was also agreed that the product would reach the end of its life somewhere between eight and ten years time. This was confirmed by Jennifer Brown who believed PPL would have developed a new product in that time. It was agreed that the life of the project should be considered as 10 years. Anna then detailed other increases in factory cost that she and Tom had identified. There would be an increase in factory wages. The operation of the machine was essentially an unskilled job but would require an increase in the number of employees. The additional cost in wages for the first year was $150,000. There was expected to be no further increases in the number of employees but wage rates were expected to increase by 2% per year over the ten year life of the project. Anna said there would be a significant increase in variable factory overheads such as power, water, consumables etc, and she and Tom had completed an analysis and felt that these expenses varied directly with sales and for forecasting purposes would use 18% of both the new product sales and contract sales as the estimate of this cost. Both she and Tom felt that this was accurate enough for the cost projections. Tom added that there was one other major cost that could not be ignored. In the first two years the new equipment would be covered by warranty for major part replacement but that after this an allowance should be included for spare parts replacement. Tom had estimated a cost of $15,000 in year 3, $30,000 in year 4 and $50,000 in year five. After that the maintenance cost would only increase by the 2% per annum being forecast for general price increases. Tom had also stated that inventory levels would increase by $150,000 mainly due to the psyllium husk and finished goods. He was confident however that, after the initial increase prior to the launch of the new product, inventory levels would not increase by any more than the $150,000 over the life of the project as the logistics manager was maintaining tight control over inventory levels. Miguel then tabled the advertising budget. Miguel stated that a significant amount would be needed in the first two years to ensure that the message regarding the elimination of side effects reached its target audience. He estimated $375,000 would be spent in years one and two. The advertising costs would then fall to $300,000 in year 3 and $275,000 in year 4. From year 5 the advertising costs would be kept to a maximum of $150,000 per year with reductions in volume offsetting any increases in price. Anna then tabled some concerns that she had with the project. Her first concern was with the building modifications. The accountants had stated that as the building modifications did not substantially improve the building or increase the life of the building the tax office had given written advice that the modifications could be claimed as a tax deduction at the time the expense was incurred. As the amount was significant, for accounting purposes, she would allocate the expense to the profit and loss account over the life of the project. Similarly the tax office would allow the depreciation of the new equipment to be claimed over an 8 year life (12.5%) but for accounting purposes the equipment will be depreciated over the life of the project (10%). The depreciation for accounting purposes will also take into account the expected sale value at the end of the project which is expected to be $185,000. The company's accountants had also stated that all the preliminary expenditure, totalling $332,000 on research, overseas trips and legal expenses could be written off to the profit and loss statement over the life of the project. They had also confirmed that the tax deduction for these preliminary expenses is claimed in the year the expense is paid. Anna was also concerned regarding the increase in working capital arising out of the increase in the level of receivables. PPL allow all customers sixty days to pay their monthly accounts and this will lead to an increase in receivables of approximately $193,000 in the first year alone. A schedule of the expected increase in receivables balance is attached as appendix 1. Anna's major concern however was the inclusion of the contract sales in the analysis. It had taken a long time to build up the current contract manufacturing business and this business was very variable. Powder mixing was a new area of manufacture and there were many other competitors in this area. She felt the equipment should be justified by the new product only. She also felt that the new product sales could be optimistic by as much as 5%. Miguel and Freddy disagreed with this and had a different opinion and believed that the sales could be as much as 10% higher. Anna also provided the following additional information: 1. The company is a profitable company and pays tax at the corporate tax rate of 30% PPL's Board have stated that the Board require a nominal rate of return of 15% on all investments in the pharmaceutical business 2. Tom and Anna had agreed that if the forecast contract manufacturing sales did not eventuate the factory wages cost would be reduced by $50,000 in the first year in addition to the elimination of all the directly variable costs. 3. As the company did not have sufficient cash to pay for the machine in full Anna had negotiated a fully amortised loan with the bank for $500,000 at a fixed rate of 7.5% p.a. that would be made available if the project went ahead. The monthly repayments were $7,669 over 7 years Freddy instructed Anna to prepare a recommendation to the Board. The base case (most likely) project should be based on the ten year sales forecasts shown in appendix 1 including the contract manufacturing sales. APPENDIX 1 Pelican Pharmaceuticals Ltd Sales Forecasts Years 1 to 5 New Product Contract Manufacturing 1 2 3 4 5 1,500,000 2,000,000 2,750,000 3,000,000 3,060,000 250,000 300,000 375,000 450,000 500,000 Raw Material Costs Years 1 to 5 1 2 3 New Product -450,000 -600,000 -825,000 Contract Manufacturing -67,500 -81,000 -101,250 4 -900,000 -121,500 5 -918,000 -135,000 Lost Sales of Current Product Years 1 to 5 1 2 3 4 5 Current Product -575,000 -750,000 -1,000,000 -1,020,000 -1,040,400 Variable Costs Current Product Years 1 to 5 Current Product 155,250 202,500 270,000 275,400 280,908 Forecast Receivables Balances Years 1 to 5 Year End Closing Balance 193,151 254,795 349,315 399,452 414,181 Note: That for all the above sales and costs the forecasts for years 6 - 10 only increase by 2% per year to allow for general inflation. The year-end receivables balance is expected to increase by 2% per annum during years 6 to 10. Required: Anna has asked you to join the small finance group and assist her in the preparation of a recommendation to the Board. You are to prepare the following: 1. A readable spreadsheet clearly showing the discounted cash flow analysis as required by the board. These spreadsheets should be based on the full ten year project as instructed by Freddy Ferguson the CEO. The calculations must include the NPV of the project and the IRR. 2. Readable spreadsheets that analyze the concerns that Anna has regarding the forecast sales for contract manufacturing and the accuracy of the sales forecasts as indicated by Anna, Freddy and Miguel