The project involving the introduction of a new over-the-counter (OTC) product should be rejected by Austrochemicals Ltd (AL).
Reasons for Rejection
This is due to the project's unfavorable Net Present Value (NPV), both when contract transactions are included and when the related cash flows associated with these additional contract manufacturing sales are excluded. In each of these scenarios, a negative NPV means that the company's owners would be best off if AL's management makes little investment in this project at all, rather than overinvesting to the point that the project has a negative NPV when discounted over its 6-year existence.
Analysis of NPV
Undertaking the project would imply that is it is being taken on when its current value is on the negative side arising in six years’ time when the nominal annual rate of return of 15% required by AL’s Board on all investments in the pharmaceutical business is used.
IRR Analysis
Analysis of AL’s investment in this project using the IRR method solidifies the recommendation that the project should indeed be rejected. The IRR is a measure that represents the discount rate that is applied to the cash flows of a project to bring its NPV to zero. The IRR for the base project is 23.35%, which could be an indication that the project can be accepted since it is greater than the discount rate that would have been used if an NPV analysis were undertaken instead (15%). When looking at the second analysis where the relevant cash flows associated with the extra contract manufacturing sales are removed (if the forecast new contract manufacturing sales do not eventuate), however, it shows that the project should not be accepted since the IRR is then 4.58%. This is way below the discount rate that would have been used if an NPV analysis were undertaken instead (15%).
Alternative Financing Options
There are other factors that the company should consider with respect to the new product project. First, the company may look into alternative sources of financing apart from the loan. With the $50,000 fully amortized loan with the firm’s bank at a fixed rate of 7.5% p.a., annual repayments on the loan amount to $92,028. Payment of this amount over the seven years severely affects the company’s cash flows on the project, which are harmful to the NPV. AL may consider alternative sources of funding like equity.This analysis is based on the assumption of a perfect capital market, which implies that if a company can identify project that has a non-negative NPV, then it is able to obtain the needed funds from the capital market. The rate at which the cash flows are discounted reflects the project’s level of systematic risk. The analysis here only considers debt financing that has been mentioned in the case. This is only one type of capital investment. Other sources of financing are equity (ordinary and preferred share capital); and the firm’s retained profits. In considering the alternative sources of financing, perhaps the NPV would not be negative, implying that AL can accept the project.
Rate of Return and Risk Assessment
The other important assumption used in the analysis is that the discount (15%) that is the nominal annual rate of return required by the AL’s Board on all investments in the pharmaceutical business is a correct reflection of the degree of risk involved in the project. If the management feels that this rate does not reflect such risks, they may hold a discussion with the board to outline to them the risks that are specific to this project. If the board is able to approve a different rate that can be used to discount the incremental cash flows for this project, then the analysis may result in different NPV and IRR that may necessitate acceptance of the project.Other factors that may be taken into consideration to improve the outlook of this project include reduction of the advertising rates which seem to have been quoted on the higher side, and less pursuit of the contract manufacturing sales that seem to further affect the acceptability of the project.
