The Cough Syrup Case
Everyfall,fluseason hits theEastCoastofthe UnitedStates.Theworld-famousGiraffeCompanyislooking to setup aplanttoproducea newtypeofcoughmedicine tocompetewithPfizer’sRobitussinbrand of cough syrup.ThemaincomplaintagainstRobitussin is that itis notpotent enoughtoeffectivelysuppressseverecoughing. Notonlydoesexcessivecoughing decreaseproductivity,it isalsoveryannoying. Thenewproduct,called“CoughCough NoMore!”,willbebasedona newformula thathasfourtimesthepotencyof Robitussinwithoutanyofthesideeffects.
Theplant isexpectedto lastfor25years.Theinitialcostis$65million. Thiscostcan bedepreciatedover15 yearsusing straightlinedepreciation.Thesalvagevalueoftheplantequipmentafter15years is
$3million in realterms.After15 years,theplant willberenovated inorder to ensure that it cancontinueproducinghigh quality medicine.Thecostoftherenovation willbe$10 million in realtermsand canbe depreciatedusing straightlinedepreciation overtheremaining 10years oftheplant’s life.Thesalvagevalueofthe equipment inthe plantaftertheremaining 10yearswillbe$2million in realterms. Theplant isto bebuilt in WestPhiladelphia(near theWharton campus),and theland couldotherwiseberentedout for$1.5 milliona year in realtermsfor25 years.
Theplant canproduce10million bottlesof cough syrup peryear.Thepriceofabottleofcough syrup iscurrently$3.50.Analystsexpectthat thispricewill growat a rateof5%peryearin real termsforthefirst5years,then at2% per yearinrealtermsforthenext5 years,and finally at0%peryear in realtermsthereafterfortheremainderof theplant’slifetime.TheGiraffeCompanyexpectstobeableto sell allthecough syrup thatit produces.Thecostofingredientsand packagingfor each bottleofcoughsyrup is currently$1perbottle.Thesecostsareexpected togrowby1%peryearin real termsthroughthe lifeofthe project. The totallaborcostsofoperating theplantareexpectedtobe$5million innominalterms inthe firstyear ofproduction andthisisexpectedto increase at5%peryearin realtermsthereafter.
Economicforecastersbelievethe rateof inflation willbe3%peryearoverthelifetimeof theplant.Thefirm’stotaltaxrate(including local taxes) is35%peryear.The firmhasotherprofitablelinesof businesssoitcanoffsetanylossesfromthemedicineplantfortax purposes.Theopportunitycostofcapital forthistype ofprojectis 10%peryear in nominalterms. Todayis date 0;allcashflows occur attheendofthe year unlessotherwisestated.
Instructions:
For all dollarvalues,pleasegiveyouranswertothenearest $1000dollars,unlessexplicitlystatedotherwise.Forexample,ifyour answeris$390,213,924pleaseenter390214. Forpercentages,pleasegive your answeras a decimalto threedecimalplaces.Forexample, ifyouranswer is11.22%pleaseenter0.112.Wehighly recommendyou usea spreadsheetprogramsuch asExcelto solvethiscase,although it ispossibletosolveitwithoutone.
Case Questions
1.Whatisthesalvagevalueoftheplantequipmentafter15years,innominalterms?
2.Whatisthevalueofthedepreciationtaxsavingperyear,innominalterms,inthefirst15years?
3.Whatisthecostoftherenovationattheendof15years,innominalterms? Thisisacost(sonegativecashflow),butpleaseenterhereasapositivenumber.
4.Whatisthevalueofthedepreciationtaxsavingsperyear,innominalterms,inthelast10yearsoftheplant’slifetime?
5.Whatisthemarket(nominal)priceofabottleofcoughsyrupattheendofthe1styearofproduction?
6.What isthe revenue (price perbottle timesbottles sold) innominal terms,forthe10thyearof production?
7.Whatisthenominalvalueoftotallaborcostsinthelast(25th)yearofproduction?
8.Whatisthenominalvalueoftheafter-taxrentallossopportunitycost inyear25?
9.Whatisthetotalnominalcashflowinyear15?
10.Whatisthetotalnominalcashflowinyear25?
11.Whatisthe15yearnominaldiscountfactor?
12.Whatisthe25yearnominaldiscountfactor?
13.Whatisthediscountedcashflow(DCF)foryear15?
14.Whatisthediscountedcashflow(DCF)foryear25?
15.WhatistheNetPresentValue(NPV)oftheproject?
16.Shouldthefirmundertaketheproject?
17.WhatistheIRRofthisproject,innominalterms?
18.Thefirmspent$20milliononanextensivemarketsurveyseveralyearsago.HowdoesthisaffecttheNPVoftheproject?
19.Ifthelandthattheplantistobebuiltoncouldberentedoutfor$6millionayearinreal termsfor25years,insteadof$1.5million,whatistheNPVoftheproject?
20.Thefirmhasanotheropportunitytobuildacookieplantinsteadofthecoughsyrupplant.ThecookieplantprojecthasanIRRof55%andanNPVof$35million.Thetwoprojectsaremutuallyexclusive.Whichprojectshouldthefirmundertake?