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Executive Summary

This report concern with the evaluation of the two production facilities for Salza

Pharmaceuticals. The medicine Cholo 2 that is prime product and yields high revenue for the

company therefore, the evaluation of two options is mentioned in this work, so that high

profitability option can be highlighted for enhancing the wealth of the shareholders.

Alternative A has a utile life span of approximately 9 years on the other hand the alternative B

has a useful span of life of 4 years. NPV and IRR Methodology of Capital Budgeting have been

utilized to ascertain the profit yield by projects. Both the alternatives have positive NPV and the

IRR is also greater than the needed rate of return of the investors. Hence, these two options are

viable for implementation. Capital budgeting tools are actually applied to wipe out the effects of

unequalize lives also for examination of the profitability of the project from different zones.

The break-even factors also calculated to comprehend the price, units or variable cost that will be

feasible for the company. The sensitivities of some significant factors is also assessed just to

identify the importance of these factors and the direct effect that they would place on the NPV of

the project. Lastly, the likelihood of taking the equipment on lease or the purchase has also been

taken into consideration at the end of the report.

Introduction

Salza-Pharmaceuticals is one of the renounced manufacturing company of medicine which was

established in 1995. This is one of the top notch manufacturer of cholesterol bursting drug Cholo

2. In addition to this the company also listed in Stock Market.

It possessing a signed contract for advertisement and marketing for Cholo 2, so as to boost the

sales of the product. Now a days it is already start working on a licensing deal for the gel

offering treatment and rapid relief of arthritis. Other than that the company also producing some

supplements of health and vitamins.

The primary fiscal flow of the company is directly related from the overall sales of Cholo 2.

The report concern with the feasibility of the acquirement of a new production facility, the

available option and net cash flows which are related with them. Since both the products have

unequal lives the options are to be examined in terms of effectiveness and make judgement over

the viability of the projects.

Analysis of Options

Incremental Cash Flows (Appendix 2)

The inclusion or exclusion of the following items in the cash flow is going to discussed here.

Interest Expense of $2 million loan can be included in the incremental cash flow, as the

bank loan would be financed against this project. Hence, it reveals that an expense that

has been incurred for the project and must be included for calculation of the net cash flow

table.

The $95000 incurred last year in rehabilitation of the plant and that would not be

presented in the overall cash flows statement because it is a sunk cost. This cost was not

been incurred for the project so, it will not be added in the cost of project.

The decrement in sale of current products and its associated costs must be included in the

cash flows because the income that will be lost in a result of the project is the opportunity

cost to implement the project and it has to be added in the cash flow analysis.

NPV and IRR Analysis(Appendix 3)

Overall Present Value is the surplus of existing value of cash inflows overall the cash outflows of

the project. The cash flows for the project life are economical at the needed rate of return to get

NPV of the project. If the NPV of the project is towards positive side then it may be expected to

produce shareholder wealth and may be undertaken by the company.

IRR states about the return that is expected to be generated from the project if the project is

undertaken. For a project to be results given, it is essential that the internal rate of return is higher

than the needed rate of return.

The productivity and value formation of a project is determined utilizing these tools of Capital

Budgeting. They are immensely viable. But if the projects have unequal lives the effectiveness of

these tools changed.

Here, the NPV is greater for Option A as it is producing cash flow for greater number of years

and IRR is greater for Option B. Hence, in this Option A is suggested because it is producing

higher value in comparison to Option B. Since, the overall lives of the projects are unequal

application of other principle budgeting tools to examined for them is suggested.

Unequal Lives Project(Appendix 4 & 5)

Whenever the projects are regarded as unequal lives either Replacement Cost Method or Annual

NPV Method applied in order to assessment of the profitability of the projects.

In Annual NPV Method the viability NPV for every year is made into calculation. It implicit that

sum of NPV that can be generate on an average in a year. In the substitution cost method, the

project with lesser time frame is reassessed by purchasing the asset in the needed financial year

and the flow of cash is determined once again. In this case, option B has a project life of four

years whereas the Option A has a life of nine years Hence, the replacement cost method has to be

applied on the Option B and accordingly examination has been made.

In this case, after making adjustment for unequal lives the NPV of option B is greater than the

NPV of Option A and Hence Option B can be suggested in terms of A.

In the old scenario, the Option A has higher NPV when compared to Option B. The rationale

behind the same was that since the project was for long time frame the in cash flows from the

project for the whole duration is considered in comparison to Option B which had shorter time

frame for cash flows as the project was for short duration. It resulted in higher NPV for the

Option A.
Sensitivity Analysis(Appendix 6)

Sensitivity Analysis actually studies the impact of different variables on the NPV of the project

when they are altered keeping the other variables constant. This methodology helps in assessing

the variable project.

In this case study, it has been observed that four variables raw material, selling price cost and

salvage value of the project varies so as to assess their sensitivity upon the NPV of the project.

The sensitivity has been estimated according to Project A, as the project was available for the

time period of nine years.

In Sensitivity Analysis the optimistic and pessimistic overview is adopt for understanding the

impact of the variables over the NPV of the project under these two scenarios.

If the difference among NPV in normal and NPV in sensitivity analysis is adopted it may be seen

that per unit sales and selling price per unit is different every time the NPV largely and they have

to be investigated with full care if the project is under implementation stage.

Both the variables are depends over each other because of which they are regarded as most

crucial. The unit sales of the product has been calculated to be higher side Hence, a small

percentage of change in the unit result in change of higher number of units of the product that

have drastic influence the flow of cash and the NPV of the project.

Break Even Analysis(Appendix 7)

Break even refers to the point over which the project will neither be giving losses nor making

profits. Any receipt after this would be known as an income for the project.

Here the break even units, the break even sale price and the break even variable cost have been

calculated for the two products.

If the crack even investigation is assessed it can be affirmed that Option A is superior than

Option B as its split even units are junior, split even sale price is lower and split even rate is high.

The underlying principle behind the same is that the predetermined cost assurance for Option A

is lesser as compare to the predetermined cost assurance for Option B which is making it more

realistic. Initially, the fixed expenditure cost is lesser for Option A but after the fourth year an

overhaul cost has to be incurred which outcome in high permanent expenses for Option A from

that year which slowly but surely lower it NPV.

Due to the above cause, the suggestion in this case is unlike because the parameters of Option A

are improved here.

Discussion on Leases

working Lease refers to the let out that is in use for short term period and the leaseholder has to

pay the lease rental to use the lease invention. After the end of the lease time, the ownership of

the manufactured goods leftovers with the lesser. The major benefit of this kind of lease is that

the lease rentals are comparatively lesser. The main drawback of this kind of lease is that they

usually finish in a very short extent of time and may not get extensive if necessary by the lessor.

Finance Lease refers to the lease that is in use for long period of time. In general, the possession

of the leased items is transfer to the lessor following the ending of the lease. The lease rentals are

intended in such a style that the lease rent over the phase of lease is capable to cover up the price

of the items all along with interest. The benefit of this sort of lease is that the lease is for a larger

period. The shortcoming for this category of lease is that the lease rentals are usually elevated.

In the specified case, if the leases are incorporated as well the proprietor has four option: to

execute Option A, to execute Option B, take the tackle on an in use lease or take the equipment

on a finance lease.
If the appliance is taken on lease, the hazard of procure would stay with the lessor and for a

longer term the lease may be additional classy. On the other hand, if the administration is not

sure of the demand for the item in the upcoming years it is additional feasible to obtain an

operating lease for the item and pay for the possessions in the following years when the demand

for the items is more exactly quantifiable. The tools occupy enormous principal speculation for

the companies. Their worth speedily decrease consequently, the resale worth of these tools

normally not high even if they have been use for less period of time. As a result, if the task turns

out to be unbeneficial and the corporation wants to cease in the case of procure it might have to

acquire losses while in the case of operating lease it can resume the equipment without the

unease of its market value.

Recommendation

These two options have their own set of advantage and disadvantage Hence; they have to be

examined cautiously before opting any option. In the case of Option A, the useful life of the

equipment is nine years; it needs an overhaul expense in the 5th year and has lower Rate of return

when make comparison to Option B. If the Annual NPV is observed they are also higher for

Option B.

In Option B, the useable life of the machine is 4 years and it has greater rate of return and also

higher Annual NPV.

Hence, in overall perception the Option B looking more profitable. On the other hand, the useful

life of the machine is four years only which is a principle constraint. At the end of four years, if

there is no possibility of machine replacement it would become a big problem for the company

because it would immediately affect the business operations. The price of the machine can also
not be estimated in reliable wa. Hence, if the product cost increases in a very high proportion it

can become lesser profitability than Option A.

This implies that, even though Option B looks more profitable at the moment but it has its own

set of associated risks and opting the option is at the discretion of the company.

Appendices

Appendix 1 Weighted Average Cost of Capital

Computation of Weighted Average Cost of Capital

Sl.

No. Particulars Value

a Value of Investment $10,000,000

b Value of Debt $2,000,000

c Interest Rate 7%

d Tax Rate 30%

e Cost of Debt 4.90%

f Weight of Debt 0.2

 g Value of Equity $8,000,000

h Required Rate of Return 15%

i Weight of Equity 0.8

j Weighted Average Cost of Capital 12.98%

Appendix 2

Option A

Sl. No. Year 0 1 2 3 4

a Initial Investment -1225000

b Salvage Value

c Overhauling Expense

d Raw Material Expense -125000 -128750 -132613 -136591

e No. of units 680000 680000 680000 680000

f Selling Price Per unit 5.70 5.90 6.11 6.32

g Variable Cost per Unit 2.50 2.56 2.63 2.69

 h Contribution per unit 3.20 3.34 3.48 3.63

i Incremental Contribution 2176000 2269160 2366006 2466676

j Annual Fixed Cost -150000 -153750 -157594 -161534

k Advertisement Cost -45000 -46125 -47278 -48460 -49672

l Interest Expense -140000 -140000 -140000 -140000

m Depreciation on Initial Investment -116667 -116667 -116667 -116667

n Depreciation on Over-hauling

Incremental Income Before Tax

o
and Opportunity Cost -1270000 1598208 1682715 1770673 1862214

p Tax @30% 0 479463 504815 531202 558664

Incremental Income After Tax and

q
Before Opportunity Cost -1270000 1118746 1177901 1239471 1303550

r After Tax Opportunity Cost -518000 -518000 -518000 -518000

s Depreciation added back 116667 116667 116667 116667

t Incremental Cash Flow -1270000 717413 776567 838137 902216

Sl. No. Year 5 6 7 8 9

a Initial Investment

b Salvage Value 175000

c Overhauling Expense -250000

d Raw Material Expense -140689 -144909 -149257 -153734 -158346

e No. of units 680000 680000 680000 680000 680000

f Selling Price Per unit 6.54 6.77 7.01 7.25 7.51

 g Variable Cost per Unit 2.76 2.83 2.90 2.97 3.05

h Contribution per unit 3.78 3.94 4.11 4.28 4.46

i Incremental Contribution 2571317 2680078 2793115 2910589 3032667

j Annual Fixed Cost -165572 -169711 -173954 -178303 -182760

k Advertisement Cost -50913 -52186 -53491 -54828

l Interest Expense -140000 -140000 -140000 -140000 -140000

m Depreciation on Initial Investment -116667 -116667 -116667 -116667 -116667

n Depreciation on Over-hauling -50000 -50000 -50000 -50000 -50000

Incremental Income Before Tax and

o
Opportunity Cost 1657477 2006605 2109747 2217057 2559894

p Tax @30% 497243 601981 632924 665117 767968

Incremental Income After Tax and

q
Before Opportunity Cost 1160234 1404623 1476823 1551940 1791925

r After Tax Opportunity Cost -518000 -518000 -518000 -518000 -518000

s Depreciation added back 166667 166667 166667 166667 166667

t Incremental Cash Flow 808900 1053290 1125489 1200606 1440592

Option B

Sl. No. Year 0 1 2 3 4

a Initial Investment -575000

b Raw Material Expense -125000 -128750 -132613 -136591

c Revenue 3876000 4011660 4152068 4297390

d Annual Fixed Cost -150000 -153750 -157594 -161534

 e No. of units 680000 680000 680000 680000

f Selling Price Per unit 5.70 5.90 6.11 6.32

g Variable Cost per Unit 2.50 2.56 2.63 2.69

h Contribution per unit 3.20 3.34 3.48 3.63

i Incremental Contribution 2176000 2269160 2366006 2466676

j Interest Expense -140000 -140000 -140000 -140000

k Depreciation on Initial Investment -143750 -143750 -143750 -143750

l Advertisement Cost -45000 -46125 -47278 -48460 -49672

Incremental Income Before Tax and

m
Opportunity Cost -620000 1721125 1809382 1901183 1996664

n Tax @30% 516338 542815 570355 598999

Incremental Income After Tax and

o
Before Opportunity Cost 1204788 1266567 1330828 1397665

p Depreciation added back 143750 143750 143750 143750

q Opportunity Cost -518000 -518000 -518000 -518000

r Cash Flow -620000 830538 892317 956578 1023415

Appendix 3 NPV and IRR

Option A

Computation of NPV

Cash

Year Flow PV @12.98%

 0 -1270000 -1270000

1 717413 634991

2 776567 608381

3 838137 581180

4 902216 553738

5 808900 439427

6 1053290 506452

7 1125489 478994

8 1200606 452260

9 1440592 480316

NPV 3465740

IRR = 62%

Option B

Computation of NPV

Year Cash Flow PV @12.98%

0 -620000 -620000

1 830538 735119

2 892317 699063

3 956578 663309

4 1023415 628124
 NPV 2105615

IRR = 108%

Appendix 4: Annual Net Present Value

Annual Net Present Value =Net Present Value

Annuity Discount Factor for the project Life

Option A

Computation of Annual NPV

Sl. No Particulars Values

A NPV 3465740

B Annuity Factor for the project life 5.135

C Annual NPV 674925.009

Option B

Computation of Annual NPV

Sl. No Particulars Values

A NPV 2105615

B Annuity Factor for the project life 2.978

C Annual NPV 707056.615

Appendix 5: Replacement Chain Method

Option B
Cash Flow for 9 years

Sl. No. Year 0 1 2 3 4

a Initial Investment -575000

b Raw Material Expense -125000 -128750 -132613 -136591

c Revenue 3876000 4011660 4152068 4297390

d Annual Fixed Cost -150000 -153750 -157594 -161534

e No. of units 680000 680000 680000 680000

f Selling Price Per unit 5.7 5.8995 6.105983 6.319692

g Variable Cost per Unit 2.5 2.5625 2.626563 2.692227

h Contribution per unit 3.2 3.337 3.47942 3.627465

i Incremental Contribution 2176000 2269160 2366006 2466676

j Interest Expense -140000 -140000 -140000 -140000

k Depreciation on Initial Investment -143750 -143750 -143750 -143750

l Advertisement Cost -45000 -46125 -47278.1 -48460.1 -49671.6

Incremental Income Before Tax

m
and Opportunity Cost -620000 1721125 1809382 1901183 1996664

n Tax @30% 516337.5 542814.6 570354.9 598999.2

Incremental Income After Tax and

o
Before Opportunity Cost 1204788 1266567 1330828 1397665

p Depreciation added back 143750 143750 143750 143750

q Opportunity Cost -518000 -518000 -518000 -518000

r Cash Flow -620000 830537.5 892317.3 956578.1 1023415

Sl. No. Year 5 6 7 8 9

 a Initial Investment -575000 -143750

b Raw Material Expense -140689 -144909 -149257 -153734 -158346

c Revenue 4447799 4603472 4764594 4931354 5103952

d Annual Fixed Cost -165572 -169711 -173954 -178303 -182760

e No. of units 680000 680000 680000 680000 680000

f Selling Price Per unit 6.540881 6.769812 7.006755 7.251992 7.505812

g Variable Cost per Unit 2.759532 2.828521 2.899234 2.971714 3.046007

h Contribution per unit 3.781349 3.941291 4.107522 4.280277 4.459804

i Incremental Contribution 2571317 2680078 2793115 2910589 3032667

j Interest Expense -140000 -140000 -140000 -140000 -140000

k Depreciation on Initial Investment -143750 -143750 -143750 -143750 -143750

l Advertisement Cost -50913.4 -52186.2 -53490.9 -54828.1 -56198.8

Incremental Income Before Tax

m
and Opportunity Cost 1520965 2199233 2306617 2418276 2390622

n Tax @30% 456289.6 659769.8 691985.2 725482.9 717186.5

Incremental Income After Tax and

o
Before Opportunity Cost 1064676 1539463 1614632 1692793 1673435

p Depreciation added back 143750 143750 143750 143750 143750

q Opportunity Cost -518000 -518000 -518000 -518000 -518000

r Cash Flow 690425.7 1165213 1240382 1318543 1299185

NPV of above Cash Flows

Computation of NPV

Year Cash Flow PV @12.98%

 0 -620000 -1270000

1 830538 735119

2 892317 699063

3 956578 663309

4 1023415 628124

5 690426 375067

6 1165213 560268

7 1240382 527891

8 1318543 496686

9 1299185 433169

NPV 3848696

Appendix 6: Sensitivity Analysis

Sensitivity Analysis Variables with Values

Variables Pessimistic Normal Optimistic

Unit Sales 442000 680000 918000

Sale Price 4.275 5.7 7.125

Raw Materials -162500 -125000 -87500

Salvage Value 0 150000

NPV OF Sensitivity Variables

Variables Pessimistic Normal Optimistic

Unit Sales 319931.2983 3465739.9 6611548.55

Sale Price -437983 3465739.9 7369462

Raw Materials 3317139 3465739.9 3614341

Salvage Value 3430060 3460643

Difference between Normal NPV and Sensitivity NPV

Variables Pessimistic Normal Optimistic

Unit Sales -3145809 0 3145808

Sale Price -3903723 0 -3903723

Raw Materials -148601 0 148601

Salvage Value -35680 0 -5097

Appendix 7: Break Even Computation

Option A

Break Even Units

Sl. No. Particulars Amount

a Amount of Fixed Cost 1095790

b Contribution per unit 3.2

c Break Even Units 342434

Break Even Sale Price

Sl. No. Particulars Amount

a Amount of Fixed Cost 1095790

b No. of Units 680000

c Fixed Cost per unit 1.61

d Variable Cost per unit 2.5

e Break Even Sale Price 4.11

Break Even Variable Cost

Sl. No. Particulars Amount

a Amount of Fixed Cost 1095790

b No. of Units 680000

c Fixed Cost per unit 1.61

d Selling Price per unit 5.70

e Break Even Variable Cost 4.09

Option B

Break Even Units

Sl. No. Particulars Amount

a Amount of Fixed Cost 1122875

b Contribution per unit 3.2

c Break Even Units 350898

 Break Even Sale Price

Sl. No. Particulars Amount

a Amount of Fixed Cost 1122875

b No. of Units 680000

c Fixed Cost per unit 1.65

d Variable Cost per unit 2.5

e Break Even Sale Price 4.15

Break Even Variable Cost

Sl. No. Particulars Amount

a Amount of Fixed Cost 1122875

b No. of Units 680000

c Fixed Cost per unit 1.65

d Selling Price per unit 5.7

Break Even Variable

e
Cost 4.05