Pharma-C is a large firm in the pharmaceutical industry which manufactures and sells a portfolio of blockbuster drugs at steady margins. The firm is currently all-equity financed and has excess cash of $100 million, which is invested in short-term marketable securities at the risk free rate. The firm’s pre-tax annual operating profit (EBIT) equals $150 million and is expected to remain constant in the future. The firm plans to maintain its assets at the current levels in the foreseeable future. The beta of the firm’s operating assets equals 0.89 and there are 70 million shares outstanding. Since the firm is expected to generate stable cash flows in the future, management is considering a leveraged recapitalization through an open market share repurchase program. The firm plans to buy back $700 million worth of shares by paying out its excess cash and issuing $600 million of bonds. Pharma-C is expected to maintain the new capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 5%. The firm’s marginal corporate tax rate is 21%. The risk free rate equals 3% and the market risk premium is 5%.

With this information answer the following four questions.

(i) Calculate the value of Pharma-C’s operating assets and the value of the firm prior to the announcement of the recapitalization. Show all your calculations.  

(ii) Calculate the stock price of Pharma-C when the recapitalization plan is announced to the market, and determine how many shares the firm needs to repurchase in the transaction. Motivate your approach and show your calculations.  

(iii) Determine Pharma-C’s cost of equity and its cost of capital after the share repurchase. Show all your calculations.  

(iv) Now suppose that the firm announces instead that it plans to issue $750 million of debt to repurchase shares, and the stock price upon announcement equals $25.70. If we assume the marginal corporate tax rate for the firm is unchanged and that issue costs associated with the debt issue are negligible, what is the market’s estimate of the firm’s expected costs of financial distress at this debt level? Motivate your approach and show all your calculations. 

Answer rating: 100% (QA)

part 1 To calculate the value of PharmaCs operating assets and the value of the firm prior to the announcement of the recapitalization we will use the Capital Asset Pricing Model CAPM and the Gordon G... View the full answer