Real Option One of your colleagues pointed out that instead of starting construction before the FDA approval, the company can invest only $0.8 B next year (depreciated over 10 years) and delay the remaining $1.2 B investment (depreciated over 8 years) for two years until the drug gets approved. Only if the drug gets approved will Fosbeck proceed with the second stage investment, which will take place in three years. The sales will commence in four years at the level of $10 B with subsequent annual growth of 50% over the next three years, after which the sales will be stable for another 5 years due to delay the company will lose two years of revenues. The probability of patent obsolescence remains the same as before 5% each year. What is the NPV of this two-stage investment? Is the option to delay the project valuable? Explain. Pharmaset, Inc. Acquisition The reason of the low probability of FDA approval for Fosbuvir is that another company, Pharmaset, Inc., is working on a similar drug, called FosbuvirP, and is very close to getting FDA approval and a patent. If Pharmaset gets a patent, Fosbecks own application will be denied. Therefore, instead of developing Fosbuvir internally, Fosbeck can acquire Pharmaset. Pharmaset already has manufacturing facilities in place and FosbuvirP is its only product. The book value of the companys fixed assets is $3 B, which will be depreciated using the straight-line depreciation over the next 10 years. Pharmaset expects to receive the FDA approval and patent by the end of this year with sales starting next year. Its next year revenues are expected to be $4 B ($10 B revenue in case of success times the 40% probability of success) with subsequent annual growth of 50% over the next three years, after which the sales will be stable for another 7 years. After that the drug will lose the patent protection and its manufacturing is expected to stop. The CoGS are expected to be 15% of revenues and SG&A expenses are $3.5 B a year if the drug is produced and zero otherwise. In other words, in case of FDA approval Pharmasets revenues and costs will be similar to Fosbecks, but SG&A expenses will be higher. If Fosbeck were to acquire Pharmaset, it would be able to bring SG&A costs down to Fosbecks level. The probability of FDA approval is 40% and the probability of patent obsolescence remains the same as before 5% each year. Mergers and Acquisitions. Target (Pharmaset) Valuation Pharmasets management would be open to the sale in the valuation range of $ 20 to 24 Billion. Please estimate Pharmasets value to Fosbeck, if it gets acquired. Recommendations Upon reviewing Fosbecks choices, what project(s) would you recommend? Venture Capital Financing 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: 1. 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. In the case of bankruptcy 20% ownership of the companys equity will apply to the book value immediately 2. 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. 3. 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.