Where Do We Draw The Line?

As Cecil shuffled through the stack of files on his desk and clicked away on his mouse, his mind kept racing back to what Jason, his boss, had said to him at the last budget meeting. We can only fund two or three new projects over the next year, he said, And up to a maximum capital investment of around $275 million. Youve got to be highly selective, he cautioned. The analysts have been rather critical of our last two product acquisitions, and our stock price does not need any further jolts! Cecil Nazareth was the business development manager for ProChem Pharmaceuticals, a fairly large company with manufacturing facilities in four countries and sales and research and development centers all over the world. He had seen the firm go through two major restructurings during his 20-year career with ProChem and was instrumental in making a number of their product acquisition decisions. Cecil reported directly to the chief financial officer, Jason Schmidt, who had been recently moved into that position as a result of their last merger.The firm had gone through a series of right-sizing attempts and managerial transformations in recent years. Somehow, Cecil had survived it all. Obviously, his smart decisions and sharp foresight had served him well over the years. Unfortunately, their last merger had taken its toll on the companys stock price. With a number of the firms patents expiring in the next three years, and most of its products far from getting final FDA approval, there was pressure to expand the product line. As a result, the last couple of product acquisitions were made rather hastily, at the insistence of the prior CFO, Bill Piper, despite Cecils negative comments and concerns. One thing that Cecil had consistently warned against was the use of an arbitrary hurdle rate when deciding on new product acquisitions. Cecil was a firm believer in the use of the weighted average cost of capital (WACC) when evaluating project cash flows. Bill, on the other hand, preferred to use a baseline rate of 13% and would begin negotiations at a discount rate of 20%. While this strategy had resulted in a few good acquisitions, Cecil, was aware that sooner or later it would come back to haunt them. Their last two acquisitions, an anti-inflammatory drug, BruPain, and an anti-allergy medication, Immunol, were made using a discount rate assumption of 14%. Cecil was highly skeptical because he felt that with their 20-year bonds selling to yield 12.69% at that time, 14% would be too low to cover the 6% risk premium that analysts had typically required on the firms equity. Well get by with debt financing on these two acquisitions, was Bills way of justifying the decision, paying little heed to Cecils concerns. We have to get some more products in our portfolio, he remarked. After the announcement of ProChems last merger with Standard Chemicals, Bill Piper took early retirement, and was replaced by Jason Schmidt, who had been serving as Standard Chemicals VP of finance. Unlike Bill, Jason preferred to be more objective and selective when evaluating new product acquisitions. He had heard about Bills arbitrary investment decision rule and had made it a point to tell Cecil that he disagreed with it. I would rather that you estimate the firms marginal cost of capital using market value weights and flotation costs, he had said to Cecil during one of their earlier discussions. It has worked really well for us at Standard Chemicals, he said with pride. I totally agree, Cecil had replied, I have been trying to convince Bill for years, but he would not buy it, he said shrugging his shoulders. At Jasons request, Cecil had set up a project team and asked them to come up with some proposals for acquisitions. Use a 10-year forecast, he recommended, and figure out what the residual value will be after 10 years. After careful analysis, the project team had come up with four recommendations: an ophthalmology product, an antiviral drug, an anticancer medication, and an antibiotic. The detailed projections and other relevant information are shown in Tables 17 below. All four products had fairly good projections and looked profitable over the 10-year horizon, but having been burned the last two times, Cecil couldnt help wondering, Where do we draw the line?

Table 1

Antiviral Product

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

(Figure in 000s)

Total Sales

250

7,200

12,000

14,400

14,400

14,400

14,400

14,400

14,400

Total COGS

31

756

1,200

1,404

1,404

1,404

1,404

1,404

1,404

Gross Profit

219

6,444

10,800

12,996

12,996

12,996

12,996

12,996

12,996

Total Operating Expense

1,000

1,115

7,312

5,520

6,624

6,624

6,624

6,624

6,624

6,624

EBIT

(1,000)

(896)

(868)

5,280

6,372

6,372

6,372

6,372

6,372

6,372

Taxes

(380)

(341)

(330)

2,006

2,421

2,421

2,421

2,421

2,421

2,421

Net Income

(620)

(556)

(538)

3,274

3,951

3,951

3,951

3,951

3,951

3,951

Working Capital Investment

43

1,212

2,004

2,395

2,395

2,395

2,395

2,395

2,395

Net Cash Flow

(17,000)

(620)

(556)

(538)

3,274

3,951

3,951

3,951

3,951

3,951

3,951

Residual Value

31,860

Total Cash Flow

(17,000)

(620)

(556)

(538)

3,274

3,951

3,951

3,951

3,951

3,951

35,811

66

Table 2

Antiviral Product

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

(Figure in 000s)

Total Sales

250

7,200

12,000

14,400

16,800

19,200

19,200

19,200

19,200

Total COGS

31

756

1,200

1,404

1,638

1,872

1,872

1,872

1,872

Gross Profit

219

6,444

10,800

12,996

15,162

17,328

17,328

17,328

17,328

Total Operating Expense

1,000

1,115

7,312

5,520

6,624

7,728

8,832

8,832

8,832

8,832

EBIT

(1,000)

(896)

(868)

5,280

6,372

7,434

8,496

8,496

8,496

8,496

Taxes (38%)

(380)

(341)

(330)

2,006

2,421

2,825

3,228

3,228

3,228

3,228

Net Income

(620)

(556)

(538)

3,274

3,951

4,609

5,268

5,268

5,268

5,268

Working Capital Investment

43

1,212

2,004

2,395

2,794

3,193

3,193

3,193

3,193

Net Cash Flow

(14,000)

(620)

(599)

(1,707)

2,482

3,560

4,210

4,868

5,268

5,268

5,268

Residual Value

42,480

Total Cash Flows

(14,000)

(620)

(599)

(1,707)

2,482

3,560

4,210

4,868

5,268

5,268

47,748

67

Table 3

Ophthalmology Product

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

(Figure in 000s)

United States Sales

11,616

46,464

104,544

185,856

290,400

Europe Sales

1,613

8,064

24,192

48,384

100,800

241,920

403,200

504,000

Asia Sales

5,702

22,810

51,322

91,238

142,560

Total Worldwide Sales

1,613

8,064

24,192

65,702

170,074

397,786

680,294

936,960

Total COGS Gross

323

1,613

4,838

13,339

34,810

81,346

139,238

192,360

Profit

1,290

6,451

19,354

52,363

135,264

316,440

541,056

744,600

Total Operating Expense

157

191

9,585

10,788

13,504

52,465

68,361

78,093

121,244

160,519

EBIT

(157)

(191)

(8,295)

(4,336)

5,850

(102)

66,903

238,347

419,812

584,081

Net Income

(102)

(124)

(5,392)

(2,819)

3,802

(66)

43,487

154,926

272,878

379,653

Working Capital Investment

(297)

(1,187)

(2,968)

(7,682)

(19,335)

(42,118)

(52,288)

(47,620)

Net Cash Flow

(150,000)

(102)

(124)

(5,688)

(4,006)

835

(7,748)

24,151

112,808

220,590

332,033

68

Table 4

Antibiotic Product

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

(Figure in 000s)

Net United States Sales

55,000

50,000

60,000

60,000

55,000

50,000

47,500

45,125

42,869

40,725

Total COGS

4,400

4,000

4,800

4,800

4,400

4,000

3,800

3,610

3,430

3,258

Gross Profit

50,600

46,000

55,200

55,200

50,600

46,000

43,700

41,515

39,439

37,467

Total Operating Expense

3,661

4,789

3,922

4,059

4,201

4,348

4,500

4,658

4,821

4,989

EBIT

46,939

41,211

51,278

51,141

46,399

41,652

39,200

36,857

34,619

32,478

Taxes (35%)

16,429

14,424

17,947

17,899

16,240

14,578

13,720

12,900

12,117

11,367

Net Income

30,510

26,787

33,331

33,242

30,159

27,074

25,480

23,957

22,502

21,111

Working Capital Investment

8,668

7,880

9,456

9,456

8,668

7,880

7,486

7,112

6,756

6,418

Net Cash Flow

(119,000)

31,456

27,575

31,755

33,242

30,947

27,862

25,874

24,332

22,858

21,449

Residual Value

Total Cash Flows

(119,000)

31,456

27,575

31,755

33,242

30,947

27,862

25,874

24,332

22,858

21,449

69

Table 5

ProChem Pharmaceuticals Income Statement (000s)

Total Revenues

416,497

Total Cost of Revenues

243,981

Gross Profit

172,516

Total Operating Expenses

75,855

Income (loss) from Operations

96,661

Interest Expense

(1,693)

Interest and Other Income, Net

3,903

Income (loss) Before Income Taxes

98,871

Provision (benefit) for Income Taxes

34,605

Net Income

64,266

Dividends Paid

30,848

Dividends Per Share

1.73

70

Table 6

ProChem Pharmaceuticals Balance Sheet (000s)

Cash and Cash Equivalents

182,382

Accounts Payable

13,761

Short-Term Investments

94,557

Accrued Liabilities

35,058

Accounts Receivable, Net

56,951

Deferred Revenue

13,277

Inventories

78,894

Deferred Income Taxes

2,447

Deferred Income Taxes

14,283

Short-Term Debt

5,581

Other Current Assets

5,666

Current Maturities of Long-Term Obligations

263

Total Current Assets

432,733

Total Current Liabilities

70,387

Property and Equipment, Net

11,605

Long-Term Debt (125,000 Bonds Outstanding, 12% Coupon 20-Year Original Maturity)

125,000

Deferred Income Taxes

Goodwill

21,474

Common Stock, $0.001 Par Value, 60,000,000 Shares Authorized; (17,782,000 Shares Outstanding)

18

Intangible Assets, Net

13,978

Other Assets

6,278

Additional Paid-in Capital

173,968

Retained Earnings

116,695

Total Shareholder's Equity

290,681

Total Assets

486,068

Total Liabilities and Shareholders Equity

486,068

71

Table 7

Other Relevant Information Regarding ProChems Capital Components

Treasury Bond Yield = 5%

Equity Beta = 1.50

Risk Premium over Bond Yield = 6%

Market Risk Premium = 9%

Current Bond Price = $925

Remaining Maturity on Bonds = 19 years

Corporate Tax Rate = 38%

Current Stock Price = $18

Flotation Costs:

Debt:

5% of Selling Price

Equity:

0$50 million = 10% of Selling Price

50M 200M = 15% of Selling Price

Questions

6.What is ProChems cost of new common stock?

7.Develop an investment opportunity schedule (IOS) for ProChem.

8.How many break points will the firms marginal cost of capital schedule (Marginal cost of capital schedule) have? Why?

9.Develop the firms MCC schedule. Note: For the cost of new equity, use the average cost of retained earnings duly adjusted for flotation costs.