Finance assignment: Investment Project by Bionomics Ltd

Question

Task: Bionomics Ltd. is a clinical stage biopharmaceutical company, which discovers and develops therapeutics for cancer and diseases of the central nervous system. The company operates through following segments: Drug Discovery and Development, and Contract Services. Bionomics was founded in 1998 and is headquartered in Thebarton, Australia.

You have been engaged as a consultant to evaluate an investment project into a new drug for the company. The drug is expected to be on the market for three years. If the project is initiated, it will require an expenditure on research and development of 4% of the total amount that Bionomics spent on research and development in the last financial year (2019). Also, an investment in a new production facility, which is estimated to cost $1.5 million, will be necessary. Bionomics uses the straight-line method to depreciate the production facility over three years. At the end of the project life (year 3), the production line can be sold for 20% of its initial cost. It is assumed that the tax rate for the project is 30%.

The product revenues for years 1, 2 and 3 are expected to be 58%, 56%, and 54% of the total revenue that Bionomics has in the last financial year. The cost of goods sold is projected to be $800,000 in years 1 and 2, but only $500,000 in year 3. The selling, general and administrative costs are assumed to be $300,000 in years 1 and 2 but only $200,000 in year 3. In addition, the drug will reduce the demand and therefore the cash flow obtained from an existing drug by $200,000 each year.

In years 1 to 3, the inventory of the project is $500,000, receivables are 15% of the project revenues, and payables are 20% of the project’s cost of goods sold. Assume that the project requires no cash and the full value of the change in working capital due to the project will be recovered in year 4 (i.e. after the project ends).

To obtain the latest financial statement of Bionomics, go to Bionomics homepage, then under ‘Investor relation’, click ‘Financial reporting’. When estimating the project details, use data for the most recent year (2019) for which the financial statements are available. Annual report for 2020 has not been available at the time the assignment is written.

Please note that the above revenue and cost estimates have not taken into account future inflation rates. To estimate the inflation rate for future years, you can use the average growth rate of consumer price index (CPI) over the last 5 years. Quarterly data on CPI can be obtained from RBA website.

Q1. Calculate the appropriate WACC of the project. State and justify your assumptions used in the calculation.

Q2. Analyse the project to arrive at the cash flow for the project.
Present in a table the incremental cash flow of the project for investment activities, operating activities, working capital, and lastly, the total incremental cash flow of the project.

Q3. Write the model or equation for NPV, IRR and the payback period and explain the advantages and disadvantages of each method. Calculate the NPV, IRR and the payback period of the project. In calculating NPV, please explain how you deal with inflation. Comment on your findings and give your recommendations.

Q4. Perform a sensitivity analysis to show the change in the NPV with respect to the following variables: product revenues, investment cost, and cost of capital.

Q5. Your report will be submitted to the executives, so the presentation matters. Make sure your report has a cover sheet, an executive summary and a final conclusion. The marks will be given according to how well the report is written and presented.

Answer

Introduction
Capital projects are considered as crucial for the organization as it involves huge amount of risk as well as investment, therefore careful consideration is required. In this aspect, present finance assignment contains analysis of the capital project by Bionomics Ltd by application of capital budgeting techniques such as net present value method, internal rate of return method, and payback period method. Moreover, sensitivity analysis with respect to revenue, cost of investment, and cost of capital is also explained in this study.

Main analysis
Question 1
It is computed by following formula –

Computation of cost of equity =
Beta 5 year monthly (From yahoo finance) = 3
10 years government bond yield = 1.32
Market risk premium (Implied market risk premium: Australia, 2020) = 4.86
Cost of equity by application of Capital asset pricing model

= Rf+ Market risk premium*Beta
= 1.32+4.86*3
= 15.9
Total equity (from annual report) =$17698141
Total debt (from annual report) =$8647490
Financial cost (from annual report) = $2364301

Rate of interest
= Financial cost/total debt
= 2364301/8647490*100
= 27.4%
After tax rate of interest
= 27.4 %( 1-30%)
= 19.18%

Table 1 Computation of weighted average cost of capital
(Source:Bionomics Limited Annual Report 2019, 2019)
(Amount in $)

Therefore,
WACC of company = 16.98%
The above computed WACC for the company is similar with the cost of capital for the project. The reason behind the same is that, it is assumed proportion of capital investment in the project is similar with the proportion maintained in the debt and equity by the company. In other words it can be said that, 32.823% of total investment is financed by borrowing from the outsiders and 67.177% of the total investment is financed by using fund of the company.

Question 2
Computation of cash flow from investment

Table 2Incremental cash flow of the project from investment activities

Cash flows from operating activities –
Amount of depreciation
= Cost –Salvage value/Life
= (1500000-300000)/3
= $400000

Table 3 Calculation of cash flow from operating activities
(Amount in $)

Computation of working capital

Question 3
Equation or model of NPV, IRR, and Payback period, and its advantages and disadvantages –

Net present value:
Equation of the NPV method is as follows –

NPV = Present value of cash outflows – Present value of cash inflows
NPV method is considered as technique for analyzing the profitability of a specific project. It considers the time value of money, which is one of the important elements for analyzing actual profitability from project. The value of the cash flows in the future is less that their present value. Another benefit from the NPV method is related to its comprehensiveness. The cited method takes into account all inflows, outflows, time period, as well as involved risk (Gupta, 2017). On the other side, there is some limitation of this method such as discounting rate, distinct projects are not comparable, and multiple assumptions.

IRR method:
Equation of the IRR method is as follows –
IRR is considered as easy technique to compute and offers a simple means by which worth among the projects could be compared in better manner. Further, this method also considers time value of money concept, so that real values of the cash flows could be ascertained. It can be said that, with the help of IRR, owner of the project could ascertain about the greatest probable cash flows would be generated from the capital projects. However, the cited method also has some limitation (Sarwary, 2020). In this, one of the major disadvantages from this method is, it consider that profits are reinvested at the internal rate of return for the balance life of project. Therefore, in case if the company is not capable to generate average rate of return equivalent with the internal rate of return, then it does not provide reliable results (Kengatharan, 2016). Payback period method:

Equation of the Payback period method is as follows –
Payback period = Initial investment/Annual cash flows
Payback period is considered as proportion of initial investment relative to the annual cash flows, which reflects about the year in which companies could cover its initial cost associated with capital projects. It can be said that, this method is appropriate for risk analysis objective as it provide a clear picture of the extent of time that the initial investment would be at risk (Sarwary, 2019). Therefore, companies should accept those investment that has rapid payback period and do not accept those investment, which have longer payback period. Although, this method also suffers from a number of limitations such as life span of assets, time value of money, complexity in cash flows, profitability, additional cash flows, and many others (Siziba, and Hall, 2019).

Computation of Net present value method –
At the time of computation of net present value of the project, inflation rate by considering the average of last five years consumer price index is considered. Further, revenue and cost of goods sold in inflated by using this inflation rate. In this, year one is considered as base year, and on second and third year, this rate has been applied.

Calculation of inflation rate –
Table 6 Inflation rate
(Inflation in Australia, 2020)

Computation of Net present value –
Total net working capital = 1352854+1317928+1343002 = 4013785
Table 7 Statement of Net Present value
(Amount in $)

Computation of IRR –
Table 8 Statement of IRR

Payback period =
5513785 /16488867
= 0.33
Based on above calculations, decision is based on results computed from NPV method, as it is better method in comparison from other method. Since, NPV from the project is positive, therefore, it is advisable that, Bionomics Ltd should make investment in such proposal.

Question 4
Sensitivity analysis for optimistic –

Table 9 Statement of Net present value in case of optimistic situation
(Amount in $)

Table 10 Statement of net present value in case of pessimistic situation
(Amount in $)

Based on above calculations, it can be said that, even if case of optimistic and pessimistic situations, the project would provide benefit to the company, therefore it should be accepted by the Bionomics Ltd.

Conclusion
Aforementioned analysis shows that company would not generate profit from the investment in capital project. The reason behind the same is that, even company increases its cost of capital and revenue and reduces its investment cost, then also it could not assists towards generation of the profit.

References
Bionomics Limited, 2020. (Online). Available through https://in.finance.yahoo.com/quote/BNO.AX/history?period1=1404172800&period2=1561852800&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose =true[Accessed on 15 October 2020]

Bionomics Limited Annual Report , 2019. 2019. (Pdf). Available through [Accessed on 15 October 2020]

Implied market risk premium: Australia, 2020.(Online). Available through Accessed on 15 October 2020]

Inflation in Australia, 2020.(Online). Available through [Accessed on 15 October 2020]

Sarwary, Z., 2019. Capital budgeting techniques in SMEs: A literature review. Journal of Accounting and Finance, 19(3).

Siziba, S. and Hall, J.H., 2019.The evolution of the application of capital budgeting techniques in enterprises. Global Finance Journal, p.100504.

Sarwary, Z., 2020. Strategy and capital budgeting techniques: the moderating role of entrepreneurial structure. International Journal of Managerial and Financial Accounting, 12(1), pp.48-70.

Gupta, D., 2017. Capital budgeting decisions and the firm’s size. International Journal of Economic Behavior and Organization, 4(6), p.45.

Kengatharan, L., 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), pp.15-38.