E16.8. Research and Development Expenditures and Valuation (Medium) A new pharmaceutical firm has patented a technology and has committed to spending $350 million annually for the next five years to develop further products from the technol ogy. The program is currently spending $350 million on R&D, yielding $1,000 million in sales and a loss of $150 million after R&D, production and advertising costs, and taxes. However, revenues from the R&D are expected to grow by $500 million per year over the next five years, reaching $3,500 million. After that, revenues are expected to grow at 5 per- cent per year, with growth in R&D expenditures also of 5 percent per year to support the additional sales. Production and advertising costs are expected to be at the same percent- age of sales as currently. The firm requires an investment in net operating assets such as to maintain an asset turnover of 1.4. Currently net operating assets stand at $714 million.

a. Value the firm using a hundle rate for operations of 10 percent.

b. Comment on the quality of the earnings forecasts for the next three years as a basis for valuation.

c. Calculate the forecasted R&D-to-sales ratio for each of the next five years. Why is this ratio an indicator of the quality of the earnings forecasted?