MINI CASE Pharma Biotech Corporation The Pharma Biotech Corporation spent several years working on developing a DHA product that can be used to provide a fatty acid supplement to a variety of food products. DHA stands for docosahexaenoic acid, an omega-3 fatty acid found naturally in cold- water fish. The benefits of fatty fish oil have been cited in studies of the brain, the eyes, and the immune system. Unfortunately, it is difficult to consume enough fish to get the benefits of DHA, and most individuals might be concerned about the taste conse- quences associated with adding fatty fish oil to eggs, ice cream, or chocolate candy. To counter these constraints, Pharma Biotech and several competitors have been able to grow algae and other plants that are rich in DHA. The resulting chemical compounds then are used to enhance a variety of food products. Pharma Biotech's initial DHA product was designed as an additive to dairy products and yogurt. For example, the venture's DHA product was added to cottage cheese and fruit-flavored yogurts to enhance the health benefits of those products. After the long product development period, Pharma Biotech began operations in 2009. Income statement and balance sheet results for 2010, the first full year of operations, have been prepared. Pharma Biotech, however, is concerned about forecasting its financial statements for next year because it is uncertain about the amount of additional financing for assets that will be needed as Pharma Biotech Corporation the venture ramps up sales Pharma Biotech expects to introduce a DHA product that can be added to chocolate candies. Not only will consumers get the satisfaction of the taste of the chocolate candies, but they will also benefit from the DHA enhancement. Because this is anticipated to be a blockbuster new product, sales are anticipated to increase 50 percent next year (2011), even though the new product will come on- line in midyear. An additional 80 percent increase in sales is expected the following year (2012). PHARMA BIOTECH CORPORATION INCOME STATEMENT FOR DECEMBER 31, 2010 (THOUSANDS OF DOLLARS) Sales 15,000 Operating expenses -13,000 EBIT 2,000 Interest -400 EBT 1,600 Taxes (40% rate) -640 Net income 960 Cash dividends (40% payout) -384 Added retained earnings 576 PHARMA BIOTECH CORPORATION BALANCE SHEET AS OF DECEMBER 31, 2010 (THOUSANDS OF DOLLARS) Cash and marketable securities $ 1,000 Accounts payable $ 1.600 Accounts receivable 2,000 Bank loan 1,800 Inventories 2,200 Accrued liabilities 1,200 Total current assets Total current liabilities 4,600 Long-term debt 2,200 Common stock 2,400 Fixed assets, net 6,800 Retained earnings 2.800 Total assets $12,000 Total liabilities and equity $12,000 5,200 Part A Pharma Biotech is interested in developing an initial "big picture of the size of financing that might be needed to support its rapid growth objectives for 2011 and 2012 A. Calculate the following financial ratios (as covered in Chapter 5) for Pharma Biotech for 2010: (a) net profit margin, (b) sales- to-total-assets ratio, (c) equity multiplier, and (d) total-debt-to-total-assets. Apply the retum on assets and retum on equity models. Discuss your observations. B. Estimate Pharma's sustainable sales growth rate based on its 2010 financial statements. (Hint: You need to estimate the be- ginning of period stockholders' equity based on the information provided.] What financial policy change might Pharma Biotech make to improve its sustainable growth rate? Show your calculations. C. Estimate the additional funds needed (AFN) for 2011, using the formula or equation method presented in the chapter. D. Also, estimate the AFN using the equation method for Pharma Biotech for 2012. What will be the cumulative AFN for the two- year period? Part B Pharma Biotech is seeking your assistance in preparing its projected financial statements using the percent-of-sales method. Initial projected financial statements can be prepared by hand using a financial calculator or by constructing spreadsheet-based solutions. A. Prepare a projected income statement for 2011 for Pharma Biotech before obtaining any additional financing. [Hint For those who need help, follow the projected income statement shown in Table 6.7 for the GameToy Company] B. Prepare a projected balance sheet for 2011 for Pharma Biotech before obtaining any additional financing. (Hint For those who need help, follow the projected balance sheet shown in Table 6.8 for the GameToy Company] C. Based on your projected balance sheet for Pharma Biotech for 2011, what is your estimate of the additional funds needed? Why does the AFN from your initial percent-of-sales projected financial statements differ from the AFN estimated using the formula method in Item C above? D. Prepare a projected statement of cash flows for Pharma Biotech for 2011. [Hint For those who need help, follow the projected statement of cash flows shown in Table 6.9 for the Game Toy Company] Part C The following tasks or challenges are best handled by setting up spreadsheet-based methods projecting financial statements. A. Prepare projected income statements, balance sheets, and statements of cash flows for Pharma Biotech for 2012 that build upon the projections for 2011 prepared in Part B above. What is the cumulative (2011 and 2012) amount of additional funds needed? B. Calculate the total-debt-to-total assets ratio and the equity multiplier ratio (covered in Chapter 5) assuming the cumulative AFN is financed with debt funds. How would these ratios compare with the same ratios calculated for 2010 in Item A above