Cooper Laboratories - Capital Budgeting Multiple Option

Cooper laboratories; Capital Budgeting Multiple option

Executive Summary:

Cooper laboratories were manufacturer of medicine and equipments for health sector. In year 1995 most of the health payments to hospitals were made by third parties which are approximately 80% so these significant percentage leads to high cost to third parties so they made rule to paid now on the bases of fair cost associated with operation. Now, hospitals have concern about to cut their cost associated with operations.

Cooper laboratories made equipment named SONICA that lies in category of ultrasonic medical equipment. The feature of this machine was to reduce operation time and save cost more than 500 times. So after rule formation, cooper laboratories will hopeful that they can sell SONICA for those hospitals that operate 100 operations in a year.

Cooper laboratories should make some plan to meet their demand for SONICA if they want to sell its more quantity. So, as per the quantity projected they have three different options. First two options related to not expand the plant but the last option suggest to expansion in the plant. Cooper laboratories have to decide which option to choose. To find out which alternative maximize Cooper laboratories value should be determined through capital budgeting technique. Capital budgeting process was in favor of third option which was to expand the operation.

Case 26: Cooper Laboratories

Q 1: part a

Cooper laboratories decided what to do on the bases of results provided by capital a budgeting technique that involves determining the future incremental cash flows and appropriate discount rate. Let’s start with the first option in which Cooper laboratories doesn’t expand the plant and sell 50 units of SONICA while they previous able to sold 40 units of SONICA that means they would about to sell 10 more unit of SONICA. So they have $2,000,000 (200,000*10) incremental revenue, the incremental variable cost associated with it was $1,250,000 (125,000*10) so Cooper laboratories have incremental gross profit of $750,000 (2,000,000 – 1,250,000). So, there was no other incremental cost associated except for supervisory and maintenance that amounting to $200,000 (510,000 – 310,000) so earnings before tax will $550,000 ($750,000 – 200,000). Cooper laboratories have 40% tax rate so after tax cash flow would be $330,000 (550,000*(1 – 0.4)) through the life of equipment. Now, to sell 10 more units of SONICA Cooper laborites needs extra working capital. Working capital can be calculated from subtracting current liabilities from current assets. In exhibit 4, percentages of current assets and liabilities were given on the bases of sales. So, working capital on bases of sale percentage was 12% ((2%+13%+10%) – (9% + 4%). In option one the working capital requirement will $240,000 (2,000,000*12%). So, first year cash flow after tax was $90,000 (330,000 – 240,000) and remaining year cash flows were same as calculated above $330,000. Working capital will recover in the end of the equipment life which is seven years.

Q 1 part b

Now, Cooper laboratories have to discount these cash flows on 16% which was appropriate cost of capital for this project to arrive the Net present value of the option.

NPV = 90,000/1.16 + 330,000/ 1.162 +……..+ 330,000/1.166 + (330,000 + 240,000)/1.167

NPV = $1,209,400

Q 1 part c

So, now let’s move to the second option which was to increase the sale price of the SONICA. In the first year, sales increase by 5% and then $5,000 each in year 2 and thereafter till year 7. Current sale price of a unit was $200,000 so in year 1 the sale prices will $210,000 (200,000*1.05) and then $215,000 (210,000+5,000) in year 2 and $220,000 (215,000 + 5,000) in year 3 to 7. In the table below calculate the incremental cash flow after tax. Variable cost was same $125,000. Cooper laboratories sale 50 units in option 2 and previously they sold 40 units of this equipment. In capital budgeting we considered incremental cash flow which determined below.