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 technology. 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 percent 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 percentage 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 hurdle 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?