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Capital Budgeting; NPV; Calculating Cash Flows

Should Diagnostic Chemicals Proceed with the Development of the DNA-Based Genetic Testing Instrument?

Francis Erkhart, a local scientist, has recently invented a very promising and relatively simple DNA-based genetic testing instrument that allows doctors to
-threatening diseases. He has approached Diagnostic Chemicals (DC) with his invention in the hope that they wi ll further develop, test, and then commercialize the genetic-testing instrument. Erkha rt wishes to negotiate a contract with DC so his invention can be brought to market as quickly as possible.
The Director of Finance at DC, Janet Morrison, is concerned a bout the risk of the project for the com pa n y. She, together with the R&D Director, estimate that it will take fi ve years to develop and test the instr ument before it is ready for commercialization. Significa n t expenditures will be required during these f ive years; some will be capitalized, some expensed.
To begin with, the company will immediately have to invest $4,000,000 in
new development and testing equipment that has a CCA rate of 40 percent and qualifies for a 10 percent lTC.
Second, the company will have to develop and test the instrument over the next 5 years. These expenditures, provided below, qualify for a 15 percent research a nd development investment tax credit, while the remaining 85 percent is a tax-deductible expense.

Third, for the right to devel op and test the genetic testing instr ument, DC must pay Francis Erkhart $250,000 when the contract is signed. Erk hart will a lso receive a yea rly royalty of 12 percent of a ll sa les associated with the instru­ ment if it is commercialized.
The risk associated with the project concerns the possibility of commercial­
ization and sales if commercialized. Based on various scenarios regarding com­ mercialization, the possible yearly sales for these scenarios, and the probabilities of the scenarios occurring, Ja net Morrison and the R&D Director have estimated that sal es will average $5.6 million per year, once the testing instrument is com­ mercialized. If commercialized, the instrument is expected to have a sales life of
25 years.
While the risks associated with the project are great, so too are the rewards. The d irect costs of producing the genetic testing instrument, if commercialized, are forecast to be only 18 percent of sales. (This is in addition to the 12% of the sales Erkhart receives.) Factory overhead and marketing costs for the instrument are expected to be $800,000 per year.
Furthermore, the provincial government is very interested in ensuring the project proceeds and is a financial success. The province is willing to provide DC with a non-taxable cash grant of $300,000: $150,000 when the contract with Erkhart is signed and $150,000 in 2 years' time. As well, the province is willing

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to provide an interest rate buydown of 6 percent on a loan of up to $500,000 for a term of 15 years. Diagnostic Chemicals could borrow $500,000 for 15 years at a rate of 9 percent.
Diagnostic Chemicals's overall cost of capital i s 14.5 percent, but since this project is in another highly risky line of business Janet Morrison feels the compa­ ny should use a risk-adjusted discount rate of 18.5 percent to evaluate the possi­ ble investments. The company's tax rate is 23 percent.


a. Should Diagnostic Chemicals proceed with the development of the DNA­
based genetic testing instrument? Explain.

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Solution Summary

The expert examines capital budgeting, NPV and calculating cash flows.