Problem 3 INVESTMENT ANALYSIS AND PROJECT EVALUATION CDS, a pharmacy chain, is considering a 5-year trial to establish an in-store clinic in one if its US locations. Customers in this location could receive non-emergency and preventative medical care at a lower cost. If the in-store clinic concept is successful, it could be replicated throughout the US. The company has hired a consultant who has

Problem 3: INVESTMENT ANALYSIS AND PROJECT EVALUATION

 CDS, a pharmacy chain, is considering a 5-year trial to establish an in-store clinic in one if its US locations. Customers in this location could receive non-emergency and preventative medical care at a lower cost. If the in-store clinic concept is successful, it could be replicated throughout the US. The company has hired a consultant who has collected the following information:

• The trial requires an immediate investment of $800,000 in medical equipment and store infrastructure. The investment will have a 8-year economic life and will be depreciated straight-line to a salvage value of zero. After 5 years, the equipment can be sold for $400,000.
• Since the trial is part of the health care reform agenda aimed at reducing overall health care costs, CDS can immediately claim a tax credit of $50,000 if it undertakes the trial.
• The in-store clinic’s revenues are $450,000 per year (starting in year 1) and its operating cash costs (staff salaries, medical supplies, etc.) are expected to be $250,000 per year.
• The in-store clinic will require a level of Net Working Capital equal to 10% of the revenues in the following year. The working capital needs to built up immediately.
• The consultant’s fee equals $25,000 and has not yet been paid

The consultant has estimated that the relevant discount rate for an investment of this type equals 15%. The marginal corporate tax rate for CDS is 40%. Furthermore, you can assume that all cash flows will be realized at the end of each year. With this information please answer the following two questions.

• Should CDS undertake the trial and establish the in-store clinic? Motivate your approach and show all your calculations.

• ^* Now suppose that the consultant determined that if CDS does not establish the in-store clinic, the firm would lose $1,000,000 in pharmacy sales in each year of the trial if a competitor decides to open a clinic. If we assume that the probability of competitive entry equals 50%, the pharmacy’s operating profit (EBIT) margin equals 20% of pharmacy sales and the immediate investment in working capital needed to support pharmacy sales equals 30% of the sales in the following year, how does would this information affect the value of the trial clinic to CDS and the firm’s decision to invest? Clearly describe your approach and show all your calculations.

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