Question 2

Ivan Ho is reviewing the investment merits of Biogen, a fast-growing biotechnology firm. Biogen has developed several drugs, which are being licensed to major drug companies. Biogen also has several drugs in final stage trials before FDA approval. Ivan notes that two drugs recently received approval which should provide Biogen solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, Biogen's estimated annual cash flow growth rate for the next two years is 25%, and longterm growth is expected to be 12%. Because of Biogen's attractive investment opportunities, the company does not pay dividend. Biogen's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for Biogen for the most recent 12 months is provided below:

Net working capital excluding cash increased from $7,500,000 to $9,900,000.

Book value increased from $81,250,000 to $101,250,000.

Biogen currently has no debt.

Research facilities and production equipment were purchased for $8,500,000.

Biogen held non-operating assets in the amount of $900,000.

Net income for the 12 months was $20,000,000.

Biogen has a marginal tax rate of 40%.

Noncash charges for depreciation and restructuring for the 12 months were $1,300,000.

Biogen's management has indicated an interest in establishing a dividend and will fund the new drug research by issuing additional debt.

(a) Compute the current free cash flow to firm and free cash flow to equity for Biogen (to the nearest million). (15 marks)

(b) If Biogen decides to start paying a dividend, discuss the impact of the decision on FCFF and FCFE. (15 marks)

(c) If Biogen issues additional debt, discuss the impact of this decision on FCFF and FCFE. (15 marks