Finally, to further reduce its risk Fosbeck considers keeping acquired Pharmaset as a separate company. In this case Fosbeck will eventually shift its R&D to Pharmaset, which will continue as a viable business even after the initial patent expires. Therefore, we can ignore the probability of a patent becoming obsolete. However, if FDA approval is not received this year, Pharmaset will go bankrupt, in which case its assets will be sold at residual book value.

A venture capital (VC) firm Menlo Ventures is willing to provide financing of up to $5 B in acquisition of Pharmaset.

If the VC agrees to invest in Pharmaset, it plans to exit after eight years at which time it expects that the companys value would be eight times its year 8 EBIT.

Menlo Ventures offers three different ways of structuring the financing:

Straight common stock where the VC will not receive any dividend for the first four years and will receive 20% of NOPAT as a dividend for the remaining four years. The tax rate for Pharmaset is 38%. In addition, the VC will receive a 20% ownership of the companys equity at the end of eight years.

Redeemable convertible debt with 10% coupon rate (interest is tax-deductible). The debt will be converted for 15% ownership of the equity of Pharmaset at the end of eight years. In the case of bankruptcy the debt will be immediately redeemed at its face value or at the residual assets' book value, whichever number is lower.

Redeemable preferred stock with 7.5% dividend plus warrants for 15% of the equity for an exercise price of $150 M. In the case of bankruptcy the debt will be immediately redeemed at its face value or at the residual assets' book value, whichever number is lower.

Which financing method should be selected by Fosbeck? Explain your answer.

COUS ratio 15% growth 50% $2.00 SGA Fosbeck $3.50 SGA Pharmaset Pharmaset PPE. $3.00 $10.00 Revenue Project Life 10 years 38% Tax rate $0.60 R&D Pharmaset probability of a 40% 5% probability of obsolescenc WACC 12% Menlo Venture Investment $5.00 8 x EBIT Valuation multiple Pharmaset If FDA Approved Year 2017 2018 2019 2020 2021 2022 2023 2024 2025 Revenue Cost SGA, if acquire Depreciation (unconditional) EBIT Taxes NOPAT Terminal Value Pharmaset Book Value COUS ratio 15% growth 50% $2.00 SGA Fosbeck $3.50 SGA Pharmaset Pharmaset PPE. $3.00 $10.00 Revenue Project Life 10 years 38% Tax rate $0.60 R&D Pharmaset probability of a 40% 5% probability of obsolescenc WACC 12% Menlo Venture Investment $5.00 8 x EBIT Valuation multiple Pharmaset If FDA Approved Year 2017 2018 2019 2020 2021 2022 2023 2024 2025 Revenue Cost SGA, if acquire Depreciation (unconditional) EBIT Taxes NOPAT Terminal Value Pharmaset Book Value