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GSBS6130 Corporate Finance

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  • Course Code: GSBS6130
  • University: The University Of Newcastle
  • Country: Australia

Question:

Tim, the product development manager for K l i n e Pharmaceuticals (KP) joined the firm about 7 years ago. With a bachelor’s degree in chemistry and an MBA in Finance from the University of Newcastle, T i m has been fairly successful in his professional career. Prior to working at KP, Tim was responsible for the launching of three highly successful drugs at another mid-sized pharmaceutical company. It did not take long for the head-hunters to find him and shortly thereafter KP made him an offer that was too good to refuse. KP is a fairly large pharmaceutical company that has a number of patented drugs under its belt. With a number of the firm’s patents expiring in the next three years, there has been some pressure to expand its production lines. Tim has been asked to make recommendations for new investment to the Board, specifically regarding a new drug recently developed by KP’s Research Department.
 
The Vision Research division recently invented a new drug, nicknamed ClearView, for the cure of myopia, which has shown tremendous promise in the preliminary test. The project leader, Jacqueline, is very confident that this new drug could revolutionise 
the world of ophthalmology. Upon Tim’s request, she also provides some standard cost estimates if the product is approved and launched early this year.

The new drug is expected to be a block-buster, which will help to increase the company’s market share and the sales are expected to be $15 million in the first year. The sales revenue generated from this product alone is expected to grow at a rate of 12% pa in the first three years and stay in line with inflation thereafter until its patent expires in 10 years.
 
The product would be manufactured in an unused plant owned by the firm which would otherwise be leased out for $150,000 per year. Required equipment costing $6 million is expected to have a salvage value of $500,000 after 10 years, though it will be fully written off for tax purposes. Fixed costs are estimated to be $2 million per year while variable production costs are expected to be equal to 25% of sales revenue in each case. To get the project underway, additional inventory of $600,000 would be required. The company would also need to increase its accounts payable by $200,000 and its accounts receivable by $300,000. Jacqueline estimates that the net working capital committed to each production line would be maintained at 20% of its sales each year thereafter. The weighted average cost of capital is calculated to be 10%. The current inflation of 2% pa is expected to remain stable over the next 15 years, and so is the company’s tax rate of 30%. You have been asked to advise the manager whether the proposal should be adopted using NPV and IRR analyses.
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