Analysis of the case of Repulse Travel Pharmaceuticals - Coursework Example

?Investment Analysis Executive Summary This report analyses the case of Repulse Travel Pharmaceuticals, a medium-scale UK firm that has just completed the product and market research for a spray product they are planning to call “Citronex”. Repulse is not certain whether Citronex should be introduced into the market, because the management fears that the financial risks of doing so are substantial. Managers who are convinced that it should cites the potential profits and cash flows the product could bring. In analysing the merits of either side, it is determined that if the product performs as forecasted, Citronex will be profitable; however, it is also risky in that if the demand and price are lower than forecasted by even a small degree, the financial losses are magnified and may be substantial. The report recommends that Citronex be postponed for the moment until more careful studies should be made to ascertain price and demand are more higher or more stable. Table of Contents Executive Summary 2 Table of Contents 3 List of tables and figures 5 1.0 Introduction 7 1.1 Background 7 1.2 Aims and objectives 7 1.3 Methods and assumptions 8 2.0 Discussion 9 2.1 Profitability study 10 2.2 Undiscounted cash flow 10 2.3 Payback period 11 2.4 Discounted cash flow 11 2.4.1 Computation of WACC 11 2.4.2Net present value 12 2.4.3Profitability index 12 2.5 Sensitivity analysis 12 2.5.11% and 5% change in demand 12 2.5.21% and 5% change in selling price 13 2.6 Assessment of financial techniques used and effect of other business issues 14 3.0 Conclusion 15 Based on the foregoing studies, under conditions of certainty the Citronex project is profitable and assures the company of good cashflow, acceptable payback period, and net positive present value. However, under conditions of uncertainty, Citronex appears to be a risky project. This is shown by the higher 3-4% change in profit (2% change in cash flow) for every 1% change in demand, and moreso, by the 19-23% change in profit (14% change in cash flow) for every 1% change in selling price. This indicates that a slight adjustment in demand or price causes a wide swing in profit and cash flow, which casts doubt that the base figures will be realized. 15 4.0 Recommendations 15 WORDCOUNT = 2,465 excluding title, table of contents, list of tables and figures, bibliography and appendices 16 Bibliography 17 Brigham E F & Ehrhardt, M C 2011 Financial Management Theory and Practice. South-western Cengage Learning, Mason, OH 17 List of tables and figures Table 1 Summary of profit changes vs demand changes 12 Table 2 Summary of profit changes vs price changes 14 Table 3 Profit and loss study under condition of certainty 18 Table 4 Payback period under condition of certainty 18 Table 5 NPV and PI under condition of certainty 18 Table 6 NPV and PI under condition of certainty (Capex & R&D) 18 Table 7 Profit and loss study 1% drop in demand 19 Table 8 Profit and loss study 1% rise in demand 19 Table 9 Payback period 1% drop in demand 19 Table 10 NPV and PI with 1% drop in demand 19 Table 11 NPV and PI with 1% drop in demand (Capex + R&D) 19 Table 12 Profit and loss study 5% drop in demand 20 Table 13 Profit and loss study 5% rise in demand 20 Table 14 Payback period with 5% drop in demand 20 Table 15 NPV and PI with 5% drop in demand 20 Table 16 NPV and PI with 5% drop in demand (Capex + R&D) 20 Table 17 Profit and loss study 1% drop in price 21 Table 18 Profit and loss study 1% rise in price 21 Table 19 Payback period with 1% drop in price 21 Table 20 NPV and PI with 1% drop in price 21 Table 21 NPV and PI with 1% drop in price (Capex + R&D) 21 Table 22 Profit and loss study 5% drop in price 22 Table 23 Profit and loss study 5% rise in price 22 Table 24 Payback period with 5% drop in price 22 Table 25 NPV and PI with 5% drop in price 22 Table 26 NPV and PI with 5% drop in price (Capex + R&D) 22 Figure 1 Graph of profit change vs demand change 13 Figure 2 Graph of profit change vs price change 14 1.0 Introduction This report is in compliance with the coursework case, the topic of which is the Repulse Travel Pharmaceuticals PLC 1.1 Background Repulse Travel Pharmaceuticals, a UK based medium sized firm, is presently deliberating on whether or not it shall launch a new spray product “Citronex,” which has an estimated five year commercial life. The firm has spent ?150,000 on product and market research on Citronex. The following information pertains to the revenue and cost potential of the proposed product: Annual selling demand 500,000 units Unit selling price ? 7 Unit variable cost ? 5.85 Fixed cost attributable to Citronex ? 320,000 Capital expenditure ? 800,000 Life of equipment 10 years Salvage value ? 100,000 Depreciations method Straight line Capital structure: 50% equity, dividend rate of 12% 50% debt with average post tax interest rate of 8% A new member of the management staff is actively in favour of the project due to its profitability and cash flow potential. The older members are cautious about the risk involved and the firm’s ability to realize the forecasted demand and selling price. 1.2 Aims and objectives The aim of this report is to provide an analysis by which management may decide whether or not the manufacture and sale of Citronex should be undertaken. The report intends to accomplish this task by conducting an estimation, based on forecasted demand and selling price, of the profit and cash flows the company is likely to realize. Its objectives, therefore, include: 1.2.1 an estimation of profit and loss as well as cash flows based on the given information under conditions of certainty on the forecasted demand and selling price 1.2.2 an estimation of profit and loss as well as cash flows based on the given information under the likely conditions that the demand may rise or fall 1.2.3 an estimation of profit and loss as well as cash flows based on the given information under the likely conditions that the selling price may rise or fall 1.2.4 an analysis of investment returns based on payback period, net present value and profitability index, the latter two of which are computed on the basis of the weighted average cost of capital 1.3 Methods and assumptions The discussion that follows intends to assess the viability of Citronex as a potential product of the company. It aims to do this through the following methods: First, it shall discuss the potential profits and losses that the firm may incur based on the net and variable cost figures and the demand and selling price given on the assumption that these are under conditions of certainty, leaving no room for speculation. For purposes of analysis, separate net profit figures shall be calculated with the research and developments costs capitalized and charged as depreciation through the five year life of the Citronex project. Second, the report shall discuss the viability of Citronex as an investment, by computing first for the payback period, the net present value and profitability index. By convention, the net present value is the time value of present and future cash flows discounted to the present, and from which the initial investments are deducted (Droms & Wright, 2010, p. 193). The profitability index is the ratio of the present value of future cash flows to the initial investment (Shim & Siegel, 2007, p. 47). For Citronex to be viable, the net present value should be positive, and the profitability index commensurately should be greater than 1. The discount rate to be used shall be the cost of capital. Citronex becomes a more attractive investment the shorter its payback period. For comparison purposes, it is assumed that the cash flows are uniform throughout the 12 months of each year. Finally, to assess the sensitivity of the potential profits and cash flows to the company on the basis of uncertainty, the foregoing calculation shall again be undertaken assuming a change in demand, both increase and decrease thereof, by 1% and 5%. Similar calculations shall be undertaken to see the effect on profits and cash flows of an increase and then a decrease in the selling price, by 1% and then by 5%. For these purposes, no price elasticity of demand shall be assumed, as there is given no indication in the case that may support this. An assumption of a change in demand volume based on price change will be entirely speculative, without any basis in the given facts of the case. 2.0 Discussion The discussion that follows are anchored upon calculations shown in spreadsheet form in the appendix, from tables 3 to 26 in Appendices A to C. In these calculations, profits shall be calculated on before tax basis, to see the incremental increase or reduction of this project on the total profit of the company. 2.1 Profitability study Table 3 in Appendix A shows the revenues and costs towards computing the profit for the Citronex project. Annual costs and revenues are uniform. Revenues (“inflow” in the spreadsheet) are the result of multiplying the selling price of ?7 by the forecasted demand of 500,000 units. The variable cost (“VC” in the third column) is found by multiplying the unit variable cost ?5.85 by the demand. “GP” is the gross profit found by deducting variable costs from revenue. This may also be used as the contribution margin towards the fixed cost. Deprn is the depreciation expense charged from the capital equipment. It was obtained by deducting the salvage value of ?100,000 from the capital expense of ?800,000, and dividing the difference across the 10 year life of the equipment (Bragg, 2010, p. 189). Thus, per annum the depreciation expense and the fixed costs are deducted from the gross profit/contribution margin, yielding the net profit (“NET”). For the purposes of observing the effect of R&D expense, assuming it is capitalized and recovered in straight line over the five year project life, the column “R&D” shows the annual R&D charge of ?30,000 corresponding to the ?150,000 development expense. The corresponding net profit inclusive of R&D is shown as “Net-R” in the last column. For the purpose of this exercise, this figure amounts to ?155,000 annually. 2.2 Undiscounted cash flow “CF” in the eight column of Table 3 is the cash flow obtained by adding back the depreciation expense to the net profit, because depreciation is a non-cash expense (Brigham & Ehrhardt, 2011, p. 55). The cash flow per period is shown as the eight column of the table. This cash flow provides the basis for the payback period calculation that follows. 2.3 Payback period Payback period is the amount of time it takes for the initial investment to be recovered out of the cash flows from the project, as well as a measure of risk (Kinney & Raiborn, 2008, p. 555). The payback period under conditions of certainty is shown in Table 4, although payback period calculations shall also be made later under assumptions of decrease in demand and decrease in selling price. Table 4 shows the cash flow year in the first column, the cash inflow for that year in the second column, and then the outstanding unrecovered investment in the next two columns – without R&D costs in the third column, and with R&D costs in the fourth column. Here it may be seen that recovery of investment occurs in the fourth year whether R&D is included or not. Without R&D, payback period is 3 years and 2 months. With R&D, payback is in 3 years and 9 months. These are of course under the assumption, mentioned in the previous section, that cash flows are uniform for the 12 months of the year. 2.4 Discounted cash flow 2.4.1 Computation of WACC The weighted average cost of capital, or WACC, is arrived at by calculating for the weighted average of the costs of debt and equity (Hitchner, 2011, p. 228). Since capital structure shows equal weights for equity and debt, the WACC is therefore the average of the dividend rate of 12% and the interest rate on debt which is 8%, yielding a 10% WACC. This shall be used as the discount rate for the discounted cash flow calculations for the NPV and PI. 2.4.2 Net present value The net present value, or NPV, is shown in the fourth columns of tables 5 and 6, first without the R&D cost, and then including it, respectively. The net present value for both instances is positive, indicating that the investment is viable. 2.4.3 Profitability index The profitability index, or PI, is shown in the fifth columns of tables 5 & 6. Whether R&D costs are taken into consideration or not, the PI is greater than 1, and therefore the project is viable. 2.5 Sensitivity analysis Sensitivity analysis is a method that tries to determine the likely consequences of future outcomes. For instance, sensitivity analysis assesses quantitatively how much a portfolio will be valued given an adjustment in market interest rates or a change in cost of capital. It is a useful tool to assess the risk of a possible investment (Brammertz, et al., 2010, p, 23). 2.5.1 1% and 5% change in demand Similar calculations as the preceding (under conditions of certainty) are shown for the change in demand in Tables 7 to 11 for 1% change, and 12 to 16 for 5% change, seen in Appendix B. The summary for the profit changes in response to these demand changes (negative to positive) is shown in Table 1 below. Figure 1 graphs the progression of the changes. Table 1: Summary of profit changes vs demand changes Figure 1: Graph of profit change vs demand change Table 1 shows that a 1% change, either positive or negative, for demand, shows a corresponding 3.7% change in profit, indicating a relatively high risk because of the greater volatility or sensitivity of profit with respect to demand. Payback period shows recovery in either the fourth or fifth years, but discounted cash flow methods show that when R&D is included in the initial investment, the project is no longer viable (NPV is negative and PI is below 1 in Tables 11 and 16). 2.5.2 1% and 5% change in selling price Sensitivity calculations for changes in selling price show a higher risk than uncertainty in demand, with a change in profit of 22.6% for every 1% change in selling price. This is shown in the summary in Table 2 and graphically in Figure 2. The calculations are shown in Tables 17 to 21 (1% change in selling price) and Tables 22 to 26 (5% change in selling price). Under these conditions, recovery through payback is still viable for a 1% drop in selling price, but is no longer viable within the 5 years of the project with a 5% drop in selling price. For a 1% drop in selling price, NPV and PI are still viable only if R&D is not considered, but show non-viability in all other conditions. Table 2: Summary of profit changes vs price changes Figure 2: Graph of profit change vs price change 2.6 Assessment of financial techniques used and effect of other business issues The financial techniques used are consistent with financial and investment analysis theory. However, there are limitations to their effective use and at best they may advise but not guarantee the outcome of a business decision. There are several real-world considerations not taken into account by the financial techniques used, such as market fluctuations affecting price, purchasing power, interest rates, expected dividends, and the inflation rate, among others. Variable costs may change over time because some of the raw materials used in the product may be imported and therefore prone to currency exchange rate fluctuations. Furthermore, many parameters used in the calculations are estimates or proxy values at best, such as the use of WACC for discounting future cash flows. The future cash flows themselves are estimates. Finally, accounting conventions such as depreciation computations are merely representative, not definitive, of the wear and tear on equipment (Biafore, 2005, p. 369). 3.0 Conclusion Based on the foregoing studies, under conditions of certainty the Citronex project is profitable and assures the company of good cashflow, acceptable payback period, and net positive present value. However, under conditions of uncertainty, Citronex appears to be a risky project. This is shown by the higher 3-4% change in profit (2% change in cash flow) for every 1% change in demand, and moreso, by the 19-23% change in profit (14% change in cash flow) for every 1% change in selling price. This indicates that a slight adjustment in demand or price causes a wide swing in profit and cash flow, which casts doubt that the base figures will be realized. 4.0 Recommendations This study recommends that decision on the Citronex project be withheld pending information on market prospects and the longer-term direction of the economy for the next five years. There is much information not available at present that pertain to forecasting long-term market demand, the expected price elasticity of the product, and other considerations that may influence the risk scenario of the product. It is possible that added information may show that drop in price may not be likely if the price is already at the lower level of the price range for other similar products. It is also possible that demand estimated is also in the conservative range and may therefore be expected to go higher. Other prospects may also be explored, such as institutional tie-ups that ensure volume sales, or wholesale supply to retailers. Such possibilities may influence the sensitivity study to show that the product is less risky than first thought. In any case, a decision at the moment is premature. However, if a decision is required at this time, it should be in the negative in light of the great risk apparently involved. Forgoing a profit would be better than incurring substantial unrecoverable losses. WORDCOUNT = 2,465 excluding title, table of contents, list of tables and figures, bibliography and appendices Bibliography Biafore, B 2005 QuickBooks 2005: The Missing Manual. O’Reilly Media, Inc., Sebastopol, CA Bragg, S M 2010 The Ultimate Accountants’ Reference: Including GAAP, IRS and SEC. John Wiley & Sons, Hoboken, NJ Brammertz, W; Akkizidis, I; Breymann, W; Entin, R; & Rustmann, M 2010 Unified Financial Analysis: The Missing Links of Finance. John Wiley & Sons, Hoboken, NJ Brigham E F & Ehrhardt, M C 2011 Financial Management Theory and Practice. South-western Cengage Learning, Mason, OH Droms, W G & Wright, J O 2010 Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know, 6th edition. Basic Books, New York, NY Hitchner, J R 2011 Financial Valuation+ Website: Applications and Models, 3rd edition. John Wiley & Sons, Inc., Hoboken, NJ Kinney, M R & Raiborn, C A 2008 Cost Accounting: Foundations and Evolutions. Thomson South-Western, Mason, OH Shim J K & Siegel, J G 2007 Handbook of Financial Analysis, Forecasting and Modeling, 3rd edition. CCG Group, Chicago, IL Warren, C S; Reeve, J M; & Duchac, J 2011 Financial and Managerial Accounting, 11th ed. South-western Cengage Learning, Mason, OH Appendices Appendix A: 100% Certainty Table 3: Profit and loss study Table 4: Payback period under condition of certainty Table 5: NPV and PI under condition of certainty Table 6: NPV and PI under condition of certainty (Capex & R&D) Appendix B: 1% and 5% drop in demand 1% change in demand Table 7: Profit and loss study 1% drop in demand Table 8: Profit and loss study 1% rise in demand Table 9: Payback period with 1% drop in demand Table 10: NPV and PI with 1% drop in demand Table 11: NPV and PI with 1% drop in demand (Capex + R&D) 5% change in demand Table 12: Profit and loss study 5% reduction in demand Table 13: Profit and loss study 5% increase in demand Table 14: Payback period with 5% drop in selling price Table 15: NPV and PI with 5% drop in demand Table 16: NPV and PI with 5% drop in demand (Capex + R&D) Appendix C: 1% and 5% change in selling price 1% change in selling price Table 17: Profit and loss study 1% drop in selling price Table 18: Profit and loss study 1% increase in selling price Table 19: Payback period with 1% drop in selling price Table 20: NPV and PI with 1% drop in selling price Table 21: NPV and PI with 1% drop in selling price (Capex + R&D) 5% change in selling price Table 22: Profit and loss study 5% reduction in selling price Table 23: Profit and loss study 5% increase in selling price Table 24: Payback period with 5% drop in selling price Table 25: NPV and PI with 5% drop in selling price Table 26: NPV and PI with 5% drop in selling price (Capex & R&D) Read More