You are the CFO of a large industrial corporation that produces medical devices. You are considering the
Question:
You are the CFO of a large industrial corporation that produces medical devices. You are considering the acquisition of a small start-up company called Tactile Health Innovation Systems (Symbol: THIS). THIS is in the process of developing a revolutionary new device that allows users to monitor a wide range of health indicators in real time. While the device is still early in its development process and THIS has a number of technical challenges to overcome, you believe that the technology is promising, and that this device has the potential to become a huge commercial success.
It is currently Year 0, and it will be three years before you find out whether the device really works as intended. The development costs are $50mln in each of Years 1 and 2, and there are three possible outcomes when the research is completed at the end of Year 2:
THIS overcomes the technical challenges completely and the device proves very useful. In this case, you can invest in manufacturing facilities at a cost of $1 bln in Year 3 and realize profits of $200 mln every year in perpetuity, starting in Year 4. This scenario has probability 20%.
*THIS overcomes the technical challenges partially, so the device proves useful but doesn't fulfill its initial promise completely. In this case, you can invest in manufacturing facilities at a cost of $1.5 bln in Year 3 and realize profits of $100 mln every year in perpetuity, starting in Year 4. This scenario has probability 40%.
*THIS does not overcome the technical challenges, and the research does not yield a marketable product. This scenario has probability 40%.
The current risk-free rate is 5% per year. You expect that in three years the risk-free rate on a perpetual bond will be either 3% or 7% with equal probability. The outcome for interest rates is independent of the outcome of THIS's research. Assume that all probabilities mentioned in this problem are risk-neutral probabilities.
(a) Draw your decision tree in this setting. Be sure to indicate cash flows at each time and each node, and respective probabilities.
(b) What is the value of marketing the device today if THIS overcomes its technical challenges completely?
(c) What is the value of marketing the device today if THIS overcomes its technical challenges partially?
(d) What is the value of undertaking the acquisition today if THIS ultimately does not overcome its technical challenges?
(e) What is the acquisition value of THIS today?
Fundamentals of corporate finance
ISBN: 978-0470876442
2nd Edition
Authors: Robert Parrino, David S. Kidwell, Thomas W. Bates