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 = 4%

Equity Beta = 1.45

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: (PLEASE SHOW ALL WORK FOR ME CLEARLY)

1.Why do you think Jason prefers to use the WACC when analyzing product acquisitions rather than a baseline rate or the rate on the cheapest capital component?

2.How should Cecil go about figuring out the cost of debt? Calculate the firms cost of debt.

3.Why is there a cost associated with a firms retained earnings?

4.How can Cecil estimate the firms cost of retained earnings? Should it be adjusted for taxes? Please explain.

5.What are two alternative ways by which flotation costs can be included in the analysis?

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.

10.Based upon your results, where should Cecil draw the line when it comes to deciding between the four product acquisitions? Why?