The Franklin Corporation: Selling An Asset

Franklin Corporation is a large publicly traded manufacturer of pharmaceutical drugs and health equipment products with over 500 product lines. The company revenue stream is equally divided between pharm and health equipment, which provides a degree of diversification for the firm. Research and development (R&D) is a prerequisite for firms in the pharma industry. It also has high degrees of risk in product development and lengthy approval processes. The company is headquartered in Dover, Delaware, United States.

Benjie Franklin founded the company in 1968. He had developed the now famous Benjie Sports Cream muscle rub, the product that morphed into Franklin Company. The company became publicly held in 1976. Mr. Franklin still serves as the President and CEO. Over the years he has become a visible, if not colorful, spokesperson for the brand in both industries. He was introduced to healthcare products when he served as a medic in the U.S. Army. He used the GI Bill to attend a community college, majoring in chemistry. He often mentions his academic background and the fact that he only had one business course, in accounting, during his academic career. He never fails to mention that he failed the course. His temperament is generally described as crotchety and he is outspoken, which also provides many opportunities for media exposure. Mr. Franklin does not appreciate MBAs, and he shares that thought frequently. Because of the vast size of the company, however, there are a few MBAs in select positions.

The current economic conditions have been favorable. Inflation has been stable in the 3% range and the risk free treasury rate has been steady in the 5% range. The ten-year Treasury bond is 7.2%. The beta for Franklin Corporation is .8. Franklin has negligible debt. The required rate of return is 13% for Franklins risk (beta of .8) and the required rate is 10% for the industry wide beta of .5.

Because of some recent setbacks, including drug R&D projects that failed, Franklin Corporation is selling off some of its assets. One asset they want to sell is XiXcon, a wonder drug for tired feet which has a patent that will expire in three years. They do not believe the patent can be re-patented. The product would have negligible value at that point. Franklin paid Washington Analytics $75,000 to confirm this information. Furthermore, there are no additional benefits or costs associated with closing the product line. XiXcon has gross sales of $600,000,000. Expenses, including marketing and distribution are typically 2/3 of sales. Depreciation for this product is $50,000,000 annually and a salvage value at the end of the third year is $100,000,000, which equals the book value. Franklins corporate tax rate is 35%. The state corporate tax rate is zero in Delaware.

Jackson & Jackson, Inc. (J&J) has offered $400 million to Franklin for the XiXcon product. The CFO of J&J, Ms. Georgia Hamilton, MBA, represents her company regarding the offer. Her initial proposal to Franklin was cordial and she firmly expressed her opinion that the offer was more than fair.

Internal to her firm, Hamilton proposed using an industry wide beta for pharmaceuticals, which is a beta of .5, to generate the offer to Franklin. The following table provides the beta of nine firms that closely match the industry and profile of Franklin. The last two observations are anomalies, with betas vastly different from the rest of firms. Since Hamilton is familiar with the industry, she recognizes that the two firms have markets and products that are atypical of the industry. She eliminates them from the data. The second column, with the last two observations eliminated, provides the pharm industry wide beta of .50.

Table 1 Industry Beta Estimates

All Firms	Beta	Beta
Firm 1 2 3 4 5 6 7 8 9	.45 .55 .44 .48 .56 .52 .50	.45 .55 .44 .48 .56 .52 .50 1.95 2.05
Total	3.5	7.5
Industry Average Beta	.50	.833

Mr. Franklin and a team from the treasury office of Franklin are considering the offer from J&J. Mr. Franklin argues forcefully, that as the offer is evaluated, the Franklin Corporation beta should be used for valuation purposes. He reasons that it is only fair to all shareholders of the company that the Franklin beta be used.

Mr. Franklin also expressed an opinion that since Hamilton inadvertently mentioned her use of an industry beta, hed want to see what that beta looked like. Having made that pronouncement, he said that he had looked at the most closely align firms (nine in total), and that the average beta appeared similar to Franklins company wide beta. This reasoning reinforces his argument to use the company beta. (Coincidentally he was considering the same nine firms found in Table 1). Mr. Franklin was also quite animated in expressing the opinion that higher betas should be required to reflect the pharmaceutical risk associated with risky R&D projects.

YOUR MISSION

You are to evaluate the 400 million dollar offer on behalf of Franklin Corporation. Should they accept the offer? Be specific in providing a detailed analysis and explanation of how you arrived at a recommendation. Your answer should fully address Mr. Franklins insistence on using a companywide beta. This argument needs to be strong enough to convince Franklin Corporation that they are either correct or incorrect in using the company beta.

What additional insights, from your analysis, can you share with Franklin Corporation?