QUESTION $1(20$ marks$)$

MK Pharmaceuticals Ltd is considering setting up a small plant in Ruwa, Zimbabwe that would be manufacturing COVID$-19$ vaccines to supply the southern part of Africa. The initial cost of investment is $$250$ million. It is expected that $80\%$ of the initial cost of investment relates to machinery with a disposal value of $$50$ million at the end of the project.

However, the Chief Financial Officer $($CFO$)$ for MK Pharmaceuticals Ltd is worried about the risk and uncertainty related to this proposed project and feels that it should be part of the investment appraisal process. Arising from this concern, the CFO has come up with two scenarios as part of evaluating the proposed investment with the time horizon for appraisal of $10$ years.

Scenario $1$

The selling price of a unit of vaccine will be $$15$ per unit. The CFO has ascertained that the probability of a demand of $10,000,000$ units per year is $0\mathrm{.}5,$ with a probability of $0\mathrm{.}4$ that it will be $20\%$ higher, and a $0\mathrm{.}1$ probability that it will be $20\%$ lower. In this scenario the CFO expects the company to earn a contribution of $50\%$ and expects fixed overheads to be $$14\mathrm{.}5$million per year.

Scenario $2$

The selling price of a unit of vaccine will be $$15$ per unit. The CFO has assumed that

demand is certain at $10,000,000$ per year. In this scenario the CFO also expects the

company to earn a contribution of $50\%.$ However, fixed overheads are uncertain as

follows:

Fixed overheads $($$$$million$)$ Probability

$11\mathrm{.}00\mathrm{.}25$

$14\mathrm{.}10\mathrm{.}30$

$17\mathrm{.}90\mathrm{.}25$

$22\mathrm{.}10\mathrm{.}20$

Other Information

MK Pharmaceuticals Ltd pays corporate tax of $30\%$ per year. The machinery qualifies for capital allowances on a straight$-$line basis. The company has a dividend cover ratio of $2\mathrm{.}0$ times and expects zero growth in dividends.

The company has one million $$1$ ordinary shares in issue and the market capitalization $($value$)$ of the company is $$50$ million.

After$-$tax profits for next year are expected to be $$20$ million. MK Pharmaceuticals Ltd has $12\%$ irredeemable bonds in issue with a nominal value of $$100.$ The market price is $$95$ ex$-$interest, and the interest is paid semi$-$annually.

The gearing level is $40\%$ based on debt to equity ratio. MK Pharmaceuticals Ltd uses the current cost of capital to evaluate all its proposed investments.

Required:

a$)$ Calculate the current cost of capital for MK Pharmaceuticals Ltd$?(5$ marks$)$

b$)$ Evaluation the final viability of the proposed investment under the following:

$($i$)$ Scenario $1(10$ marks$)$

$($ii$)$ Scenario $2(10$ marks$)$

c$)$ Explain the reasons why risk and uncertainty should be considered in the investment appraisal process. $(5$ marks$)$

$[$Total: $30$ Marks$]$