Capital Budgeting Task

Case background

XYZ Limited manufactures medical products. The company is considering adding a new product (“Product X”) to its mix but the market for this product is thought to be riskier than the company’s current operations. However, the Board of Directors is particularly interested in the product because it has characteristics that meet their aim to become a more environmentally responsible business.

Having already spent significant funds ($1 million) on research and development of the product, the company is now close to the final investment decision stage and the CEO has asked you to put together the financial analysis of the project. You will submit a summary of your analysis, along with your recommendations on the project, in a short memo.

A market research report commissioned by XYZ  recommends producing and selling Product X for five years as technological change will likely render the product obsolete after that time. Estimated annual sales revenues for Product X in the first three years are expected to be $180 million. For each of years 4 and 5, sales revenues are expected to fall 30% on the prior year. The market research report stressed that the expected fall in revenue is subject to competition and technological advances and their estimated 30% fall has a high standard deviation.

The product development team has estimated the following operating costs and net working capital requirements associated with the project. Cost of goods sold is expected to equal 60% of sales revenues. Selling, general and administrative expenses directly related to the project (excluding depreciation) are expected to be $12 million in the first year and increase by 3% per year thereafter. It is also expected that the project will require an amount of net working capital on hand equal to 20% of each upcoming year’s sales revenue forecast. The investment in working capital will be fully recovered by the end year 5 as the project winds down.

The project requires an upfront investment in plant and equipment. The company has already received quotes on the plant and equipment costs and estimates a total of $150 million, which will be depreciated to a zero book value using the prime cost method over the five-year life of the project. XYZ plans to set up project operations in a factory it owns but currently leases to another company. XYZ’s current pre-tax profit related to this lease is $2 million per year and XYZ budgets reveal a 3% per year increase in this figure over the next five years, which aligns with external forecasts of rental growth in the area.

At the end of the project, the plant will be dismantled and equipment sold. Dismantling costs are expected to be $2 million. The estimated market value of the equipment at that time will depend on its condition but a ballpark figure of $10 million has been estimated.

Other case information:

XYZ has a 10% weighted average cost of capital and pays a 30% tax rate. For the purpose of capital budgeting, it is assumed all taxes are paid in the year of income to which they relate. The company is expected to have taxable income from other projects that could be reduced by any losses on the Product X project, which would reduce the firm’s overall tax in that year. The company is not eligible for any research development tax deductions.

Required:

Prepare a financial analysis of the proposed project and present it to XYZ’s CEO in the form of a memo. As part of your financial analysis you will calculate the five investment decision criteria detailed in the Week 4 PERCI content. In your memo, briefly explain and justify your chosen methods, inputs and any assumptions made, summarise your findings and present recommendations on the proposed project that arise from your analysis. Ensure you not only address base case cash flows but also analyse potential uncertainty. Recommendations should address the decision to be made, along with any further follow up or other matters the company should consider prior to making a final decision. Include an appendix to the memo that includes your base case figures. Within the memo body, you may provide tables and figures that assist decision makers understand your analysis, findings and their implications for decision making but ensure the tables and figures are discussed and/or explained.