RxDelivery Systems is an research and development venture specializing in the development and testing of new drug delivery technologies. The market for alternative drug delivery systems grew rapidly during the past several years. Driving factors behind this growth include efforts to reduce drug side effects through site-specific delivery, the need to maintain the activity of new biopharmaceutical compounds, and the extension of drug patent life. Improved drug delivery methods are expected to reduce the number of surgical interventions and the length of hospital stays, and to promote patient compliance in taking prescribed drugs.

The world market for biopharmaceuticals (including peptide, protein, RNA, and DNA drugs) was more than $50 billion in 2007. Sales of polymer-based drug delivery systems are forecasted to exceed $2.0 billion in 2014. Pulmonary delivery systems currently account for about one-third of the drug delivery market, and sales are projected to exceed $25 billion by 2014.

RxDelivery Systems believes it can compete effectively in both the polymer-based and pulmonary drug delivery areas. The venture’s delivery technology is expected to utilize hydrophobic ion pairing and supercritical carbon dioxide precipitation to incorporate water-soluble drug molecules into biodegradable controlled-release microspheres. The resulting microspheres will take the form of dry powders and will contain drug molecules small enough to allow for intravenous, intranasal, or pulmonary delivery. It is anticipated that this technology will be incorporated into products for controlled-release applications, including treatment of cancer, infectious diseases, and gene therapy.

RxDelivery Systems, through an agreement with its pharmaceutical parent, a major drug company, will initially operate as an independent corporation but will be merged into the parent at the end of its second year. At that time, RxDelivery Systems’ entrepreneurial team will be paid a lump sum of $2.5 million as the terminal value for the venture. Following are limited financial statement projections for the next two years for the RxDelivery Systems Corporation:

First-year revenues ......... $12,500

Second-year revenues ....... $16,000

Expenses (including depreciation) .. $125,000 per year

Initial time-zero (net) fixed assets ... $50,000

Depreciation ........... 10% of beginning-of-year net fixed assets

Accounts payable (Years 1 and 2) .. $750

Inventories (Years 1 and 2) ...... $0

Corporate marginal tax rate ..... .30%

Accounts receivable (Years 1 and 2) . $0

Accrued expenses (Years 1 and 2) .. $300

Required cash .......... $3,000

Debt (all years) ........... $0

A. Construct the venture’s balance sheet at startup. Then construct financial statements for Years 1 and 2. (Put initial fixed-asset investments in Year 0 and initial working capital investments in Year 1. Assume the initial $50,000 is equity financed.)

B. Construct the enterprise valuation cash flows, including the $2.5 million terminal payment. Treat existing liabilities at the terminal time as though the pharmaceutical firm assumes them. (The $2.5 million is “free and clear.”) Strip all nonrequired cash out of net working capital.

C. What is the value of the enterprise at time zero?

D. What is the value of the equity at time zero?

E. Why does this value differ from the value for the equity method in the RxDelivery Systems mini case at the end of Chapter 9?