You are the senior financial analyst for Fosbeck
Generic Drug Co (Fosbeck). The firm manufactures and sells generic
over-the-counter drugs in plants located throughout the country. You have been asked to generate some answers
to questions emanating from the Board of Directors. These questions can be
grouped into two broad categories – what projects to choose for the near future
and how to finance these projects.
Please present your recommendations in a
report written for your supervisor, the firm Controller. Clearly show your
analysis and communicate your conclusions and recommendations. Support your
report by calculations in the Excel spreadsheets.In your
report, explain the results of each portion of your analysis (represented by
the tabs on the Excel template). Submit all the completed Excel worksheets with
the completed responses to the questions posed to support your report and
recommendation.
Individual Project Analysis
Your first task is to analyze the company’s
three projects and provide your recommendations about their implementation.
Automation project
One of Fosbeck’s plants is trying to decide
whether to automate its drug manufacturing by purchasing a fully automated bioreactor
machine complex.
The proposed machine costs $400 M and it will have a five year anticipated
life and will be depreciated by using the 3-year MACRS depreciation method
toward a zero salvage value. (MACRS depreciation rates are: Year 1: 33%, Year
2: 45%, Year 3: 15% and Year 4: 7%) However, the plant will be able to sell the
machine in the after-market for 25% of its original costs at the end of year 5. The firm estimates that the installation of
the bioreactor will bring annual costs savings of $50 M from reduced labor costs, $10 M per year from
reduced waste disposal costs, and $80 M per year from the sales byproduct of bioreactor process net
of selling expenses. Fosbeck requires a 12% of return from its investment and has a 35% marginal tax rate.
Decision
Criteria – NPV and IRR
·
Calculate the NPV and IRR for
the project.
·
The manager of the plant raised
some concerns about the revenues from the byproduct sale. He projects that the
price of the byproduct in year 1 could be 10% to 50% less than what was projected. However, the savings from
reduced labor costs and reduced waste disposal costs would remain same. He
presented the following probability distribution on the projected reclaimed
plastic sales:
Remain same
as projected 40%
Decrease by 10% 30%
Decrease by 30% 20%
Decrease by 50% 10%
Estimate the NPV and IRR for each of
these scenarios. Estimate the expected NPV.
Break-even
Analysis
·
At what volume of byproduct
sales would Fosbeck have a break-even NPV=0?
Fosbuvir Project
The company considers development of a new drug
to treat Hepatitis C, code-named the Fosbuvir Project. Fosbeck has already
spent $420 M on preliminary
research for drug development and it will need another $600 M on development this year (tax
deductible) and $2 B
in CapEx next year (these cash outlays are
not part of the cash flows that you have estimated earlier, because this
project is not approved yet). Capital expenditures will be depreciated over 10
years using straight line depreciation.
The patent for the drug is pending and the company expects to
receive an FDA approval and start selling the drug in two years. Its expected
revenues in the first year of sales are $1 B ($10 B revenue with a 10% probability) with
subsequent annual growth of 50%
over the next three years, after which the sales will be stable for another 7 years. Even if Fosbuvir
gets approved by FDA, each year there is a 5 % probability of the patent becoming obsolete
due to a new drug entering the market, in which case the revenues will drop to
zero. After that the drug will lose the patent protection and its manufacturing
is expected to stop. The CoGS are estimated to be 15% of revenues and SG&A expenses are $2 B a year if the drug
is produced and zero otherwise.
NPV
and IRR
·
Please estimate the NPV and IRR
of the Fosbuvir Project, using the company’s WACC of 12%.
Real Option Scenario Analysis
Expected revenues and expenses take into account the uncertainty of getting
the patent and FDA approval. The company estimates the probability of getting
the approval in two years is 10%
(i.e., if the company gets the approval the revenue is $10 B, if it does not, the revenue is
zero). Even if Fosbuvir gets approved by FDA, each year there is a 5 % probability of the patent
becoming obsolete due to a new drug entering the market, in which case the
revenues will drop to zero.
Therefore, your next task is to evaluate these
two scenarios for the Fosbuvir Project (see the template) based on probability of FDA
approval in two years and patent obsolescence in each subsequent year.
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 a probability of 10%) 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, Fosbeck’s 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 company’s 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 with a 40% probability) 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 Pharmaset’s revenues and
costs will be similar to Fosbeck’s, but SG&A expenses will be higher. If Fosbeck
were to acquire Pharmaset, it would be able to bring SG&A costs down to
Fosbeck’s 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
Pharmaset’s management would be open to the sale in the valuation
range of $ 20 to 24
Billion. Please estimate Pharmaset’s value to Fosbeck, if it gets
acquired.
Recommendations
Upon reviewing Fosbeck’s choices, what
project(s) would you recommend?
Venture Capital Financing
Finally, to further reduce its risk Fosbeck
considers to keep 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 company’s
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
company’s equity at the end of eight years.
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.
Which financing method should be selected
by Fosbeck? Explain your answer.
Is it enough to submit Excel file?
No! The deliverable outcome is your written
report to the CFO. You use Excel to support your recommendations
Is there a minimum or maximum size of the report?
Although there is no formal minimum size of
the report, it has to address all issues raised and provide your analysis and
supporting evidence. To complete
the thorough analysis required for this assignment you will probably need 3-4
pages. It is also a good idea to add a one-page executive summary to your
report.
Similarly,
there is no maximum limit for the report, but please avoid adding superfluous
information to your report.
How do I explain whether the option to delay the project
valuable?
Analyze the costs and benefits of making the
capital investment in two steps and delaying the project’s positive cash flows
by two years and shortening the revenue stream.
Are preferred dividends tax deductible?
No, unlike coupon payments, preferred
dividends are not tax deductible.
How do I decide which financing option is better?
One approach would be to see which option
is less costly from Fosbeck’s management point of view.
