SILICON VALLEY MEDICAL TECHNOLOGIES

Cost of Capital

Silicon Valley Medical Technologies (SIVMED) was founded in San Jose, California, in 1992 by Kelly O'Brien, David Roberts, and Barbara Smalley. O'Brien and Roberts, both MDs, were on the research faculty at the UCLA Medical School at the time; O'Brien specialized in biochemistry and molecular biology, and Roberts specialized in immunology and medial microbiology. Smalley, who has a PhD, served as the department chair of the Microbiology Department at UC-Berkeley.

The company started as a research and development firm, which performed its own basic research, obtained patents on promising technologies, and then either sold or licensed the technologies to other firms which marketed the products. In recent years, however, the firm has also contracted to perform research and testing for larger genetic engineering and biotechnology firms, and for the U.S. government. Since its inception, the company has enjoyed enormous success - even its founders were surprised at the scientific breakthroughs made and the demand for its services. One event that contributed significantly to the firms' rapid growth was the AIDS epidemic. Both the U.S. government and private foundations have spent billions of dollars in AIDS research, and SIVMED had the right combination of skills to garner significant grant funds, as well as perform as a subcontractor to other firms receiving AIDS research grants.

The founders were relatively wealthy individuals when they started the company, and they had enough confidence in the business to commit most of their own funds to the new venture. Still, the capital requirements brought on by extremely rapid growth soon exhausted their personal funds, so they were forced to raise capital from outside sources. First, in 2001, the firm borrowed heavily, and then in 2003 when it used up its conventional debt capacity, it issued $15 million of preferred stock. Finally, in 2006, the firm had an initial public offering (IPO) which raised $50 million of common equity. Currently, the stock trades in the over-the-counter market, and it has been selling at about $30 per share.

SIVMED is widely recognized as the leader in an emerging growth industry, and it won an award in 2008 for being one of the 100 best-managed small companies in the United States. The company is organized into two divisions: (1) the Clinical Research Division and (2) the Genetic Engineering Division. Although the two divisions are housed in the same buildings, the equipment they use and their personnel are quite different. Indeed, there are few synergies between the two divisions. The most important synergies lay in the general overhead and marketing areas. Personnel, payroll, and similar functions are all done at the corporate level, while technical operations at the divisions are completely separate.

The Clinical Research Division conducts most of the firm's AIDS research. Since most of the grants and contracts associated with AIDS research are long-term in nature, and since billions of new dollars will likely be spent in this area, the business risk of this division is low. Conversely, the Genetic Engineering Division works mostly on in-house research and short-term contracts where the funding, duration, and payoffs are very uncertain. A line of research may look good initially, but it is not unusual to hit some snag, which precludes further exploration. Because of the uncertainties inherent in genetic research, the Genetic Engineering Division is judged to have high business risk.

The founders are still active in the business, but they no longer work 70-hour weeks. Increasingly, they are enjoying the fruits of their past labors, and they have let professional managers take over day-to-day operations. They are all on the board of directors, though, and David Roberts is chairman.

Although the firm's growth has been phenomenal, it has been more random than planned. The founders would simply decide on new avenues of research, and then count on the skills of the research teams - and good luck - to produce commercial successes. Formal decision structures were almost nonexistent, but the company's head start and its bright, energetic founders easily overcame any deficiencies in its managerial decision process. Recently, however, competition has become stiffer, and such large biotechnology firms as Genentech, Amgen, and even Bristol-Myers Squibb have begun to recognize the opportunities in SIVMED's research lines. Because of this increasing competition, SIVMED's founders and board of directors have concluded that the firm must apply state-of-the-art techniques in its managerial processes as well as in its technological processes. As a first step, the board directed the financial vice president, Gary Hayes, to develop an estimate for the firm's cost of capital and to use this number in capital budgeting decision. Hayes, in turn, directed SIVMED's treasurer, Julie Owens, to have a cost of capital estimate on his desk in one week. Owens has an accounting background, and her primary task since taking over as treasurer has been to deal with the banks. Thus, she is somewhat apprehensive about this new assignment, especially since one of the board members is a well-known Northwestern University finance professor.

Table 1

Silicon Valley Medical Technologies, Inc. Balance Sheet

For the Year Ended December 31, 2009

(In Millions of Dollars)

Cash and marketable securities

$7.6

Accounts payable

$5.7

Accounts receivable

$39.6

Accruals

$7.5

Inventory

$9.1

Notes payable

$1.9

Current assets

$56.3

Current Liabilities

$15.1

Long-term debt

$61.2

Net fixed assets

$114.5

Preferred stock

$15.0

Common stock

$79.5

Total Assets

$170.8

Total claims

$170.8

To begin, Owens reviewed SIVMED's 2009 balance sheet, which is shown in Table 1. Next, she assembled the following data:

(1)SIVMED's long-term debt consists of 9.5% coupons, semiannual payment bonds with fifteen years remaining to maturity. The bonds last traded at a price of $1129.50 per $1,000 par value bond. The bonds are not callable, and they are rated BBB.

(2)The founders have an aversion to short-term debt, so the firm uses such debt only to fund cyclical working capital needs.

(3)SIVMED's federal-plus-state tax rate is 40%.

(4)The company's preferred stock pays a dividend of $1.80 per quarter; it has a par value of $100; it is noncallable and perpetual and it is traded in the over-the-counter market at a current price of $104.00 per share. A flotation cost of $2.00 per share would be required on a new issue of preferred. (Although not planned at this time the company is interested in how the analysis would change if the preferred stock had a mandatory redemption provision, which specified that the firm must redeem the issue in 5 years at a price of $100 per share.)

(5)The firm's last dividend (D0) was $1.09, and dividends are expected to grow at about an 8% rate in the foreseeable future. Some analysts expect the company's recent growth rate to continue, others expect it to go to zero as new competition enters the market, but the majority anticipate that a growth rate of about 8% will continue indefinitely.

(6)An important minority of analysts have noted that over the last few years, the company has had a 14% average return on equity (ROE) and has paid out about 40% of its net income as dividends. They believe the firm's expected future growth rate, g, should be based on this information and used to estimate the cost of equity (r_s).

(7)The firm's per share dividend payment over the past five years has been as follows:

Year

Dividend

2005

$0.72

2006

$0.75

2007

$0.85

2008

$1.00

2009

$1.09

(8)SIVMEND's common stock now sells at a price of about $30 per share. The company has 5 million common shares outstanding.

(9)The current yield on long-term T-bonds is 4.5%, and a prominent investment-banking firm has recently estimated that the market risk premium is six percentage points over Treasury bonds. The firm's historical beta, as measured by several analysts who follow the stock, is 1.2.

(10)The required rate of return on an average (A-rated) company's long term debt is 7%.

(11)SIVMED is forecasting retained earnings of $1,800,000 and depreciation of $4,500,000 for the coming year.

(12)SIVMED's investment bankers believe that a new common stock issue would involve total flotation costs - including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effect - of 30%.

(13)The market value target capital structure calls for 30% long-term debt, 10% preferred stock, and 60% common stock.

Now assume that you were recently hired as Julie Owens' assistant, and she has given you the task of helping her develop the firm's cost of capital. You will also have to meet with Gary Hayes and, possibly, with the president and the full board of directors (including the Northwestern finance professor) to answer any questions they might have. With this in mind, Owens wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answer, so be sure you understand the logic behind any formulas or calculations you use. In particular, be aware of potential conceptual or empirical problems that might exist.

QUESTIONS

1.What specific items of capital should be included in SIVEM's estimated weighted average cost of capital (WACC)? Should before-tax or after-tax values be used? Should historical (embedded) or new (marginal) values be used? Why?

2.Answer the following questions regarding cost of debt.

a.What is your estimate of SIVMEND's cost of debt?

b.Should flotation cost be included in the component cost of debt calculation? Explain.

c.Suppose SIVMED's outstanding debt had not been recently traded, what other methods could be used to estimate the cost of debt?

3.Answer the following questions regarding the cost of preferred stock.

a.What is your estimate of the cost of preferred stock?

b.SIVMED's preferred stock is more risky to investors than its debt, yet you should find that its before-tax yield to investors is lower than the yield on SIVMED's debt. Why does this occur? (Hint: Lecture notes can be a good source of information for this questions.)

4.Answer the following questions regarding the cost of retained earnings (r_s).

a.Why is there a cost associated with retained earnings? (Hint: Section 9-6 in the textbook)

b.What is SIVMED's estimated cost of retained earnings using the CAPM approach?

c.Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? (Hint: Section 9-6b in the textbook)

d.How can SIVMED obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining an estimate from some other organization and also the ways in which SIVMED could calculate a market risk premium in-house. (Hint: Section 9-5 in the textbook)

5.Answer the following questions regarding the cost of retained earnings (r_s).

a.Use the discounted cash flow (DCF, or Dividend Growth Approach) method to obtain an estimate of SIVMED's cost of retained earnings.

b.Suppose SIVMED, over the last few years, has had a 14% average return on equity (ROE) and has paid out about 40% of its net income as dividends. Estimate the firm's expected future growth rate, g, based on the retention growth model?

6.Use the bond-yield-plus-risk-premium method to estimate SIVMED's cost of retained earnings (r_s) if the judgmental risk premium is 3.5%.

7.What is your final estimate for cost of retained earnings?

8.What is your estimate of SIVMED's cost of new common stock (r_e)?

9.Answer the following questions regarding the marginal cost of capital schedule.

a.Construct SIVMED's marginal cost of capital (MCC) schedule. How large could the company's capital budget be before it is forced to sell new common stock?

(Hint: https://www.cengage.com/resource_uploads/downloads/0324594690_163042.pdf )

b.Would the MCC schedule remain constant beyond the retained earnings break point, no matter how much new capital it raised? Explain, Again, ignore deprecation.

10.Should the corporate cost of capital as developed above be use by both division, and for all projects within each division? If not, what type of adjustment should be made?

11.Answer the following questions regarding weights of capital items.

a.What are SIVMED's book value weighs of debt, preferred stock, and common stock? (Hint: Consider only long-term sources of capital. Based on the balance sheet numbers and Figure 9-1 can be used as reference)

b.What are SIVMED's market value weighs of debt, preferred stock, and common stock? (Hint: Figure 9-1 can be used as reference)

c.Should book value or market value weights be used when calculating the firm's weighted average cost of capital? Why?