QUESTION 1
Omega Medical Group (OMG) manufactures high precision medical equipment. OMG has spent €20m on research and development (R&D) for a new system to administer medical isotopes used in diagnostic imaging. The device is expected to be approved by the regulatory authorities shortly and OMG is now starting to plan for production to start in 12 months time. The costs to complete the regulatory approval process are estimated to be €80m. OMG expects to sell a total of 12,000 of the devices at a fixed price of €30k over the planned production life of four years.
Initial investment for the additional plant and machinery for this project is €525m. The project will also require an increase in working capital of €50m. The working capital will be released at the end of the project. The incremental annual operating costs will be €120m. Production is expected to finish at the end of four years and all the equipment will be disposed of. Some parts of the plant are potentially dangerous and will need to be disposed of in an environmentally friendly way. There will be a net disposal cost of €40m. All cash flows are in today’s money and inflation is expected to be 2.5% per annum (p.a.) over the next five years.
Currently, investment in plant and equipment is eligible for capital allowances on a straight-line basis over four years. The applicable corporate tax rate is 28%. Capital allowances are received by OMG in the same year that they are claimed but taxes on profits are paid one year in arrears.
OMG’s shares are listed on the Paris Stock Exchange where they currently trade at €2.50 with an equity beta of 1.2. The expected equity risk premium is 10% p.a. and risk-free rate is 3% p.a. OMG currently has a market debt to equity ratio (D/D+E) of 40%. The current average before tax cost of borrowing for the company is 6% p.a. Inflation is 2.5% p.a. and is likely to remain so over the life of the project.
Required:
(a) Estimate the weighted average cost of capital (WACC) for OMG.
(b) Carry out a DCF analysis of the project based on the information given and calculate the net present value (NPV), internal rate of return (IRR) and payback of the project. Advise OMG whether the project is financially viable. Briefly explain the reasoning behind your decision. Also mention any reasons for excluding any of the information given above and explain any additional assumptions you have made whilst making your calculations.
(c) OMG are negotiating a new debt facility to provide additional funds to fund a whole new series of projects and product upgrades. The new capital structure will result in OMG’s market debt to equity ratio (D/D+E) increasing to 50%. As a consequence of the increased gearing, the before tax cost of debt will increase to 8%. The increased gearing will also change the equity market’s perception of risk at OMG. Recalculate WACC for OMG and recalculate your NPV for the project. Does this change your previous recommendation?