Vigour Pharmaceuticals Ltd. is considering investing in a new production line for its pain-reliever medicine for individuals who suffer from cardio vascular diseases. The company has to invest in equipment which costs $2,500,000 and will be depreciated under the MACRS system for a 5-year asset class. It is expected to have a scrap value of $700,000 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. Vigour Pharmaceuticals 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 pain-reliever. Expected annual sales for the product in the first three years are $600,000 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. The introduction of the new line of pain reliever will cause a net decrease of $50,000 in profit contribution due to a decrease in sales of the other lines of pain relievers produced by the company. By investing in the new product line Vigour Pharmaceuticals would have to use a packaging machine which the company already has. It is fully depreciated and could be sold at the end of the project for $350,000 after-tax in the equipment market. The companys financial analyst has advised Vigour Pharmaceuticals to use the weighted average cost of capital as the appropriate discount 3 rate to evaluate the project. The following information about the companys sources of financing is provided below: a. 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. b. Vigour Pharmaceuticals 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. c. The companys preferred stock pays an annual dividend of 4.5 percent and is currently selling for $60, and there are 100,000 shares outstanding. d. 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 is as follows: i. 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. ii. Vigour Pharmaceuticals has a marginal tax rate of 35 percent. In the event of a negative taxable income, the tax is computed as usual and is reported as a negative number, indicating a reduction in loss after tax. 4 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. 1. Determine the weighted average cost of capital (WACC) for Vigour Pharmaceuticals. (10 marks) 2. Calculate the initial cash flow of the project. (4 marks) 3. Calculate the operating cash-flows for all years of the project (8 marks) 4. Calculate the terminal cash flow of the project (4 marks) 5. 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. (4 marks) 6. Why should the cost of capital used in capital budgeting be calculated as a weighted average of the capital component rather than the cost of the specific financing used to fund a particular project? (5 marks)