Pharmos Incorporated is a Pharmaceutical Company which is considering investing in a new
production line of portable electrocardiogram (ECG) machines for its clients who suffer from
cardio vascular diseases. The company has to invest in equipment which cost $2,500,000 and falls
within a MARCS depreciation of 5-years, and is expected to have a scrape value of $200,000 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.
Pharmos Incorporated 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 product line. Expected annual sales for the ECG
machines in the first three years are $1,200,000 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 $180,000 per year over the life of the project.
Year Project A ($) Project B ($) Project C ($)
0 (Investment) -1,000 -$10,000 -$5,000
1 600 4,000 2,000
2 300 3,000 1,000
3 200 2,000 2,000
4 100 2,000 1,000
5 500 4,000 2,000
The introduction of the new line of portable ECG machines will cause a net decrease of $50,000
each year in profit contribution after taxes, due to a decrease in sales of the other lines of tester
machines produced by the company. By investing in the new product line Pharmos Incorporated
would have to use a packaging machine which the company already has and will be sold at the
end of the project for $350,000 after-tax in the equipment market.
The company’s financial analyst has advised Pharmos Incorporated to use the weighted average
cost of capital as the appropriate discount rate to evaluate the project. The following information
about the company’s sources of financing is provided below:
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. Pharmos Incorporated 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.
The company’s preferred stock pays an annual dividend of 4.5 percent and is currently selling for
$60, and there are 100,000 shares outstanding.
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 about the company follows:
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 from 2010 to 2019. Pharmos Incorporated
has a marginal tax rate of 25 percent.
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.
Required: Answer the following questions given the information above
e. What is the estimated Internal Rate of Return (IRR) of the project?
f. Should the project be accepted based on the IRR?
g. Calculate to the following for Pharmos considering its tax rate of 25 percent.
i. Total Market Value for the Firm
ii. After-tax cost of Loan
iii. After-tax cost of Bonds
iv. Cost of Equity
v. Cost of Preferred Stock
vi. Weighted Average Cost of Capital (WACC)