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?

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 firm's cost of debt.

3.Why is there a cost associated with a firm's retained earnings?

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

5.What is ProChem's cost of new common stock?

6.How many break points will the firm's marginal cost of capital schedule (Marginal cost of capital schedule) have? Why?

7.Develop the firm's MCC schedule. Note: For the cost of new equity, use the average cost of retained earnings duly adjusted for flotation costs.

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

Table 1 Antiviral Product 3 4 0 1 2 5 6 7 8 9 10 Year (Figure in 000's) Total Sales Total COGS Gross Profit Total Operating Expense EBIT Taxes Net Income Working Capital Investment Net Cash Flow Residual Value Total Cash Flow 1,000 (1,000) (380) (620) 250 31 219 1,115 (896) (341) (556) 43 (556) 7,200 756 6,444 7,312 (868) (330) (538) 1,212 (538) 12,000 1,200 10,800 5,520 5,280 2,006 3,274 2,004 3,274 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,951 31,860 35,811 (17,000) (620) (17,000) (620) (556) (538) 3,274 3,951 3,951 3,951 3,951 3,951 Table 2 Anticancer Product 3 4 0 1 2 5 6 7 8 9 10 Year (Figure in 000's) Total Sales Total COGS Gross Profit Total Operating Expense EBIT Taxes (38%) Net Income Working Capital Investment Net Cash Flow Residual Value Total Cash Flow 1,000 (1,000) (380) (620) 250 7,200 31 756 219 6,444 1,115 7,312 (896) (868) (341) (330) (556) (538) 43 1,212 (599) (1,707) 12,000 1,200 10,800 5,520 5,280 2,006 3,274 2,004 2,482 14,400 1,404 12,996 6,624 6,372 2,421 3,951 2,395 3,560 16,800 1,638 15,162 7,728 7,434 2,825 4,609 2,794 4,210 19,200 1,872 17,328 8,832 8,496 3,228 5,268 3,193 4,868 19,200 1,872 17,328 8,832 8,496 3,228 5,268 3,193 5,268 19,200 1,872 17,328 8,832 8,496 3,228 5,268 3,193 5,268 19,200 1,872 17,328 8,832 8,496 3,228 5,268 3,193 5,268 42,480 47,748 (14,000) (620) (14,000) (620) (599) (1,707) 2,482 3,560 4,210 4,868 5,268 5,268 Table 3 Ophthalmology Product 3 4 0 1 2 5 6 7 8 9 10 1,613 8,064 24,192 Year (Figure in 000's) United States Sales Europe Sales Asia Sales Total Worldwide Sales Total COGS Gross Profit Total Operating Expense EBIT Net Income Working Capital Investment Total Cash Flow 1,613 8,064 323 1,613 1,290 6,451 191 9,585 10,788 (191) (8,295) (4,336) (124) (5,392) (2,819) (297) (1,187) (124) (5,688) (4,006) 11,616 48,384 5,702 65,702 13,339 52,363 52,465 (102) (66) (7,682) (7,748) 24,192 4,838 19,354 13,504 5,850 3,802 (2,968) 835 46,464 100,800 22,810 17,074 34,810 135,264 68,361 66,903 43,487 (19,335) 24,151 104,544 241,920 51,322 397,786 81,346 316,440 78,093 238,347 154,926 (42,118) 112,808 185,856 403,200 91,238 680,294 139,238 541,056 121,244 419,812 272,878 (52,288) 220,590 157 (157) (102) 290,400 504,000 142,560 936,960 192,360 744,600 160,519 584,081 379,653 (47,620) 332,033 (150,000) (102) Table 4 Antibiotic Product 3 0 1 2 5 6 7 8 9 10 Year (Figure in 000's) Net United States Sales Total COGS Gross Profit Total Operating Expense EBIT Taxes (35%) Net Income Working Capital Investment Net Cash Flow Residual Value Total Cash Flow 55,000 4,400 50,600 3,661 46,939 16,429 30,510 8,668 (119,000) 31,456 50,000 4,000 46,000 4,789 41,211 14,424 26,787 7,880 27,575 60,000 4,800 55,200 3,922 51,278 17,947 33,331 9,456 31,755 60,000 4,800 55,200 4,059 51,141 17,899 33,242 9,456 33,242 55,000 4,400 50,600 4,201 46,399 16,240 30,159 8,668 30,947 50,000 4,000 46,000 4,348 41,652 14,578 27,074 7,880 27,862 47,500 3,800 43,700 4,500 39,200 13,720 25,480 7,486 25,874 45,125 3,610 41,515 4,658 36,857 12,900 23,957 7,112 24,332 42,869 3,430 39,439 4,821 34,619 12,117 22,502 6,756 22,858 40,725 3,258 37,467 4,989 32,478 11,367 21,111 6,418 21,449 (119,000) 31,456 27,575 31,755 33,242 30,947 27,862 25,874 24,332 22,858 21,449 Table 5 ProChem Pharmaceuticals Income Statement('000s) Total Revenues Total Cost of Revenues Gross Profit Total Operating Expenses Income (loss) from Operations Interest Expenses Interest and Other Income, Net Income (loss) Before Income Taxes Provision (benefit) for Income Taxes Net Income Dividends Paid Dividends Per Share $ $ $ $ $ $ $ $ $ $ $ Cash and cash equivalents Short-term investments Accounts receivables, Net Inventories Deferred income taxes Orther current assets Total current assets 416,497 243,981 172,516 75,855 96,661 (1,693) 3,903 98,871 34,605 64,266 30,848 1.73 $ s $ $ $ $ $ $ $ Table 6 ProChem Pharmaceuticals Balance Sheet ('000s) 182,382 Accounts payable 94,557 Accrued liabilities 56,951 Deferred revenue 78,894 Deferred income taxes 14,283 Short-term debt 5,666 Current maturities of long- 432,733 term obligations $ $ $ $ $ $ 13,761 35,058 13,277 2,447 5,581 263 11,605 Total current liabilities $ 70,387 Property and equipment, Net Deferred income taxes Goodwill Intangible assets, Net Other assets Total long-term assets s $ s $ $ $ $ $ 21,474 13,978 6,278 53,335 $ 125,000 Long-term debt (125,000 bonds outstanding, 12% coupon 20-year original maturity) Common stock, $0.01 par value 60,000,000 shares authorized; ; (17,782,000 shares outstanding) Additional paid-in capital Retained earnings Total shareholder's equity $ $ $ $ 18 173,968 116,695 290,681 Total assets $ 486,068 $ $ 486,068 Total liabilities and shareholder's equity Table 7 Other Relevant information Regarding ProChem's 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