Michael, the product development manager for Apex Pharmaceuticals (AP)joined the firm about 7 years ago. With a bachelor’s degree in chemistry and an MBA in finance from the University of Newcastle, Michael has been fairly successful in his professional career. Prior to working at AP, Michael 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 AP made him an offer that was too good to refuse. AP 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. Michael has been asked to make recommendations for new investment to the Board, specifically regarding a new drug recently developed by AP’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, Catherine, is very confident that this new drug could revolutionise the world of ophthalmology. Upon Michael’s request, she also provides some standard cost estimates if the product is approved and launched early this year.
Development costs: 21 million
Testing costs: 12 million
Initial Marketing costs: 13 million
Initial outlay: 46 million
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 $20 million in the first year. The sales revenue generated from this product alone is expected to grow at a rate of 11% 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 $125,000 per year. Required equipment costing $6 million is expected to have a salvage value of $300,000 after 10 years, though it will be fully written off for tax purposes. Fixed costs are estimated to be $1.55 million per year while variable production costs are expected to be equal to 20% of sales revenue in each case. To get the project underway, additional inventory of $550,000 would be required. The company would also need to increase its accounts payable by $110,000 and its accounts receivable by $200,000. Catherine 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 12.5%. The current inflation of 1.5% 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.
QUESTION 2: (15 Marks)
You are a research analyst in an investment bank. You need to write a research report on the sensitivity of the stock return to the market return. The following model can be used to estimate the sensitivity of the stock return to the market return:
??,?=?0+ ?1??,?+??,? (1)
Where ??,? is stock return on the ith institution; ??,? is return on the S&P/ASX All Ordinaries Index; and ??,? is the random error term at day t. You are required to estimate the market model (Eq.1)1 for the following companies:
Commonwealth Bank of Australia (CBA.AX)
Rio Tinto Ltd (RIO.AX)
Insurance Australia Group Ltd (IAG.AX)
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