Tesaro is a biotech company developing ovarian cancer treatment. The company projects annual sales of $2,150M for 10 years, after which its patent will expire. It has an EBIT margin of 40%, spends $100M per year on capital expenditures and has $50M per year of depreciations in those 10 years and 0 after. Corporate tax rate is 20%. Risk free rate is 3.0%. Tesaro's asset beta equals 1.3, and the market risk premium 8.0%. The company is all-equity financed. The number of shares outstanding is 55M.

 

A. Valuation.

(i) Find the fair value of Tesaro.

 

(ii) At its current price of $44, is Tesaro's stock over- or undervalued? Explain your answer.

 

B. Synergies. GSK is considering an acquisition of Tesaro. It belives that it can increase Tesaro's sales by 5% per year and increase the EBIT margin to 75% (depreciation stays as it is). GSK's cost of capital is 15%.

 

(i) What is the maximum price that GSK should pay for Tesaro? Explain your answer.

(ii) Should GSK use Tesaro's cost of capital or its own cost of capital to evaluate the deal? Why?