Question $2$

A pharmaceutical company is evaluating the production of a new vaccine. It will evaluate the project by discounting the expected cash flows using its WACC. The following information is known:

$6$ months ago, the firm spent $$10,000,000$ on research, development and testing in order to confirm the safety and efficacy of the vaccine.

The project requires the purchase of new equipment $($in year $0)$ for $$12,300,000.$ The new equipment has a $6-$year lifespan and will be fully depreciated under the straightline method with zero salvage value.

The project will generate sales of $$15,000,000$ per year and expenses of $$6,250,000$ per year for years $1-4$ after which the firm will no longer be producing the vaccine.

In year $1,$ the firm must increase its inventory by $$3,750,000.$ It will maintain this level of inventory until the end of year $4.$

In year $1,$ the firm anticipates an increase in accounts receivable equal to $15\%$ of sales and an increase in accounts payable equal to $10\%$ of expenses. Accounts receivable and payable are expected to remain at this level until the end of year $4.$

The project will require the firm to use a warehouse it owns $($until the end of year $4),$ that it would otherwise be renting out for $$1,750,000$ per year.

The equipment purchased for the project will be sold at the end of year $5$ for $$1,500,000.$

The firm's marginal tax rate is $26\%.$

a$)$ Compute the incremental free cash flows associated with the project for years $0-5.$

The firm would like to evaluate the vaccine project on its own as well as compare it to its other projects, which have different lifespans and different capital requirements. The firm believes that the riskiness of the cash flows associated with the vaccine project is similar to the average riskiness of its other projects. Therefore, it will use its WACC to evaluate the project. The firm currently has $60$ million shares of common stock with a book value of $$5\mathrm{.}50$ per share and a current market price of $$33\mathrm{.}75$ per share. A dividend of $$3\mathrm{.}25$ is expected to be paid next year. Dividends are projected to grow at $6\mathrm{.}00\%$ each year thereafter. The firm's outstanding bonds have a total face value of $$950$ million, a maturity of $30$ years, a $6\mathrm{.}0\%$ annual coupon, and are selling currently for $85\%$ of face value.

b$)$ Compute the firm's WACC

c$)$ Compute the NPV of the vaccine project.

$3$

Quantitative Financial Management

FIN $360$

Take$-$Home Assessment $3$

d$)$ Compute The EAA $($equivalent annual annuity$)$ and profitability index of the vaccine project.

The firms' CEO is interested in knowing what the annual return of the vaccine project is and has therefore asked you to compute the project's IRR. You are concerned however that the IRR will overstate the project's annual return because it assumes that the project's interim cash flows will be reinvested at the IRR. Instead, you believe that it is more reasonable to assume that the project's interim cash flows are reinvested at the firm's cost of capital $($WACC$).$

e$)$ Compute an IRR for the vaccine project that assumes interim cash flows are reinvested at the firm's cost of capital $($i$.$e$.$ the modified IRR$).$

The firm is considering spinning off its vaccine division, which will then operate independently as a separate entity. In its first year, the new entity is expected to have free cash flows equal to the EAA of the vaccine project $($from d$)).$ As the new entity builds up its vaccine pipeline, its cash flows are then expected to grow at a rate of $9\mathrm{.}5\%$ annually. The new entity will take on debt worth $$10\mathrm{.}5$ million from the firm, will not hold any excess cash and will have $10$ million shares outstanding. The riskiness of the new entity will be similar to the average riskiness of the firm and the new entity will face the same marginal tax rate as the firm.

f$)$ What is the share price of the new entity?