QUESTION

Introduction:

You are the senior financial analyst for Fosbeck Generic Drug Co (Fosbeck). The firm

manufactures and sells generic over-the-counter drugs in plants located throughout the country.

You have been asked to generate some answers to questions emanating from the Board of

Directors. These questions can be grouped into two broad categories – what projects to choose

for the near future and how to finance these projects.

Deliverable:

Please present your recommendations in a report written for your supervisor, the firm Controller.

Clearly show your analysis and communicate your conclusions and recommendations. Support

your report by calculations in the Excel spreadsheets. In your report, explain the results of each

portion of your analysis (represented by the tabs on the Excel template). Submit all the

completed Excel worksheets with the completed responses to the questions posed to support your

report and recommendation.

Steps to Completion:

Individual Project Analysis

Your first task is to analyze the company’s three projects and provide your recommendations

about their implementation.

Automation project

One of Fosbeck’s plants is trying to decide whether to automate its drug manufacturing by

purchasing a fully automated bioreactor machine complex.

The proposed machine costs $400 M and it will have a five year anticipated life and will be

depreciated by using the 3-year MACRS depreciation method toward a zero salvage value.

(MACRS depreciation rates are: Year 1: 33%, Year 2: 45%, Year 3: 15% and Year 4: 7%)

However, the plant will be able to sell the machine in the after-market for 25% of its original

costs at the end of year 5. The firm estimates that the installation of the bioreactor will bring

annual costs savings of $50 M from reduced labor costs, $10 M per year from reduced waste

disposal costs, and $80 M per year from the sales byproduct of bioreactor process net of selling

expenses. Fosbeck requires a 12% of return from its investment and has a 38% marginal tax rate.

Decision Criteria – NPV and IRR Calculate the NPV and IRR for the project. The manager of the plant raised some concerns about the revenues from the byproduct

sale. He projects that the price of the byproduct in year 1 could be 10% to 50% less than

what was projected. However, the savings from reduced labor costs and reduced waste

disposal costs would remain same. He presented the following probability distribution on

the projected reclaimed plastic sales:

Remain same as projected 40% Decrease by 10%

Decrease by 30%

Decrease by 50% 30%

20%

10% Estimate the NPV and IRR for each of these scenarios. Estimate the expected NPV.

Break-even Analysis At what volume of byproduct sales would Fosbeck have a break-even NPV=0? Fosbuvir Project

The company considers development of a new drug to treat Hepatitis C, code-named the

Fosbuvir Project. Fosbeck has already spent $420 M on preliminary research for drug

development and it will need another $600 M on development this year (tax deductible) and $2 B

in CapEx next year (these cash outlays are not part of the cash flows that you have estimated

earlier, because this project is not approved yet). Capital expenditures will be depreciated over 10

years using straight line depreciation.

The patent for the drug is pending and the company expects to receive an FDA approval and start

selling the drug in two years. Its expected revenues in the first year of sales are $1 B with

subsequent annual growth of 50% over the next three years, after which the sales will be stable

for another 7 years. After that the drug will lose the patent protection and its manufacturing is

expected to stop. The CoGS are estimated to be 15% of revenues and SG&A expenses are $2 B a

year if the drug is produced and zero otherwise.

NPV and IRR Please estimate the NPV and IRR of the Fosbuvir Project, using the company’s WACC of

12%. Crystal Ball

Expected revenues and expenses take into account the uncertainty of getting the patent and FDA

approval. The company estimates the probability of getting the approval in two years is 10%

(i.e., if the company gets the approval the revenue is $10 B, if it does not, the revenue is zero).

Even if Fosbuvir gets approved by FDA, each year there is a 5 % probability of the patent

becoming obsolete due to a new drug entering the market, in which case the revenues will drop

to zero.

Therefore, your next task is to evaluate the Fosbuvir Project using Crystal Ball simulation (see

the template) based on probability of FDA approval in two years and patent obsolescence in each

subsequent year. Alternatively you are welcome to use Random Data generator in Data Analysis

Pack. What is the probability of a positive NPV? Please discuss the riskiness of the project. Real Option One of your colleagues pointed out that instead of starting construction before the FDA approval,

the company can invest only $0.8 B next year (depreciated over 10 years) and delay the

remaining $1.2 B investment (depreciated over 8 years) for two years until the drug gets

approved. Only if the drug gets approved will Fosbeck proceed with the second stage investment,

which will take place in three years. The sales will commence in four years at the level of $10 B

with subsequent annual growth of 50% over the next three years, after which the sales will be

stable for another 5 years – due to delay the company will lose two years of revenues. The

probability of patent obsolescence remains the same as before – 5% each year. What is the NPV of this two-stage investment? Is the option to delay the project valuable? Explain. Pharmaset, Inc. Acquisition

The reason of the low probability of FDA approval for Fosbuvir is that another company,

Pharmaset, Inc., is working on a similar drug, called FosbuvirP, and is very close to getting FDA

approval and a patent. If Pharmaset gets a patent, Fosbeck’s own application will be denied.

Therefore, instead of developing Fosbuvir internally, Fosbeck can acquire Pharmaset. Pharmaset

already has manufacturing facilities in place and FosbuvirP is its only product. The book value of

the company’s fixed assets is $3 B, which will be depreciated using the straight-line depreciation

over the next 10 years. Pharmaset expects to receive the FDA approval and patent by the end of

this year with sales starting next year. Its next year revenues are expected to be $4 B ($10 B

revenue in case of success times the 40% probability of success) with subsequent annual growth

of 50% over the next three years, after which the sales will be stable for another 7 years. After

that the drug will lose the patent protection and its manufacturing is expected to stop. The CoGS

are expected to be 20% of revenues and SG&A expenses are $3.5 B a year if the drug is

produced and zero otherwise. In other words, in case of FDA approval Pharmaset’s revenues and

costs will be similar to Fosbeck’s, but SG&A expenses will be higher. If Fosbeck were to acquire

Pharmaset, it would be able to bring SG&A costs down to Fosbeck’s level. The probability of

FDA approval is 40% and the probability of patent obsolescence remains the same as before –

5% each year.

Mergers and Acquisitions. Target (Pharmaset) Valuation

Pharmaset’s management would be open to the sale in the valuation range of $ 20 to 24 Billion.

Please estimate Pharmaset’s value to Fosbeck, if it gets acquired.

Recommendations

Upon reviewing Fosbeck’s choices, what project(s) would you recommend?

Venture Capital Financing

Finally, to further reduce its risk Fosbeck considers to keep acquired Pharmaset as a separate

company. In this case Fosbeck will eventually shift its R&D to Pharmaset, which will continue

as a viable business even after the initial patent expires. Therefore, we can ignore the

probability of a patent becoming obsolete. However, if FDA approval is not received this year,

Pharmaset will go bankrupt, in which case its assets will be sold at residual book value.

A venture capital (VC) firm Menlo Ventures is willing to provide financing of up to $5 B in

acquisition of Pharmaset. If the VC agrees to invest in Pharmaset, it plans to exit after eight years at which time it expects

that the company’s value would be eight times its year 8 EBIT.

Menlo Ventures offers three different ways of structuring the financing:

1. Straight common stock where the VC will not receive any dividend for the first four years

and will receive 20% of NOPAT as a dividend for the remaining four years. The tax rate

for Pharmaset is 38%. In addition, the VC will receive a 20% ownership of the

company’s equity at the end of eight years.

2. Redeemable convertible debt with 10% coupon rate (interest is tax-deductible). The debt

will be converted for 15% ownership of the equity of Pharmaset at the end of eight years.

In the case of bankruptcy the debt will be immediately redeemed at its face value or at the

residual assets' book value, whichever number is lower.

3. Redeemable preferred stock with 7.5% dividend plus warrants for 15% of the equity for

an exercise price of $150 M. In the case of bankruptcy the debt will be immediately

redeemed at its face value or at the residual assets' book value, whichever number is

lower.

Which financing method should be selected by Fosbeck? Explain your answer.

Frequently Asked Questions/Helpful Hints:

Is it enough to submit Excel file?

No! The deliverable outcome is your written report to the CFO. You use Excel to support your

recommendations

Is there a minimum or maximum size of the report?

Although there is no formal minimum size of the report, it has to address all issues raised and

provide your analysis and supporting evidence. To complete the thorough analysis required for

this assignment you will probably need 3-4 pages. It is also a good idea to add a one-page

executive summary to your report.

Similarly, there is no maximum limit for the report, but please avoid adding superfluous

information to your report.

How do I set up Crystal Ball simulation?

Hint: use “Yes-No” distribution to create a binary (one or zero) variable indicating project

continuation each year. Make revenues and costs dependent values of these binary variables.

How do I explain whether the option to delay the project valuable?

Analyze the costs and benefits of making the capital investment in two steps and delaying the

project’s positive cash flows by two years and shortening the revenue stream.

Are preferred dividends tax deductible?

No, unlike coupon payments, preferred dividends are not tax deductible.

How do I decide which financing option is better?

One approach would be to see which option is less costly from Fosbeck’s management point of

view.

You are the senior financial analyst for Fosbeck Generic Drug Co (Fosbeck). The firm

manufactures and sells generic over-the-counter drugs in plants located throughout the country.

You have been asked to generate some answers to questions emanating from the Board of

Directors. These questions can be grouped into two broad categories – what projects to choose

for the near future and how to finance these projects.

Deliverable:

Please present your recommendations in a report written for your supervisor, the firm Controller.

Clearly show your analysis and communicate your conclusions and recommendations. Support

your report by calculations in the Excel spreadsheets. In your report, explain the results of each

portion of your analysis (represented by the tabs on the Excel template). Submit all the

completed Excel worksheets with the completed responses to the questions posed to support your

report and recommendation.

Steps to Completion:

Individual Project Analysis

Your first task is to analyze the company’s three projects and provide your recommendations

about their implementation.

Automation project

One of Fosbeck’s plants is trying to decide whether to automate its drug manufacturing by

purchasing a fully automated bioreactor machine complex.

The proposed machine costs $400 M and it will have a five year anticipated life and will be

depreciated by using the 3-year MACRS depreciation method toward a zero salvage value.

(MACRS depreciation rates are: Year 1: 33%, Year 2: 45%, Year 3: 15% and Year 4: 7%)

However, the plant will be able to sell the machine in the after-market for 25% of its original

costs at the end of year 5. The firm estimates that the installation of the bioreactor will bring

annual costs savings of $50 M from reduced labor costs, $10 M per year from reduced waste

disposal costs, and $80 M per year from the sales byproduct of bioreactor process net of selling

expenses. Fosbeck requires a 12% of return from its investment and has a 38% marginal tax rate.

Decision Criteria – NPV and IRR Calculate the NPV and IRR for the project. The manager of the plant raised some concerns about the revenues from the byproduct

sale. He projects that the price of the byproduct in year 1 could be 10% to 50% less than

what was projected. However, the savings from reduced labor costs and reduced waste

disposal costs would remain same. He presented the following probability distribution on

the projected reclaimed plastic sales:

Remain same as projected 40% Decrease by 10%

Decrease by 30%

Decrease by 50% 30%

20%

10% Estimate the NPV and IRR for each of these scenarios. Estimate the expected NPV.

Break-even Analysis At what volume of byproduct sales would Fosbeck have a break-even NPV=0? Fosbuvir Project

The company considers development of a new drug to treat Hepatitis C, code-named the

Fosbuvir Project. Fosbeck has already spent $420 M on preliminary research for drug

development and it will need another $600 M on development this year (tax deductible) and $2 B

in CapEx next year (these cash outlays are not part of the cash flows that you have estimated

earlier, because this project is not approved yet). Capital expenditures will be depreciated over 10

years using straight line depreciation.

The patent for the drug is pending and the company expects to receive an FDA approval and start

selling the drug in two years. Its expected revenues in the first year of sales are $1 B with

subsequent annual growth of 50% over the next three years, after which the sales will be stable

for another 7 years. After that the drug will lose the patent protection and its manufacturing is

expected to stop. The CoGS are estimated to be 15% of revenues and SG&A expenses are $2 B a

year if the drug is produced and zero otherwise.

NPV and IRR Please estimate the NPV and IRR of the Fosbuvir Project, using the company’s WACC of

12%. Crystal Ball

Expected revenues and expenses take into account the uncertainty of getting the patent and FDA

approval. The company estimates the probability of getting the approval in two years is 10%

(i.e., if the company gets the approval the revenue is $10 B, if it does not, the revenue is zero).

Even if Fosbuvir gets approved by FDA, each year there is a 5 % probability of the patent

becoming obsolete due to a new drug entering the market, in which case the revenues will drop

to zero.

Therefore, your next task is to evaluate the Fosbuvir Project using Crystal Ball simulation (see

the template) based on probability of FDA approval in two years and patent obsolescence in each

subsequent year. Alternatively you are welcome to use Random Data generator in Data Analysis

Pack. What is the probability of a positive NPV? Please discuss the riskiness of the project. Real Option One of your colleagues pointed out that instead of starting construction before the FDA approval,

the company can invest only $0.8 B next year (depreciated over 10 years) and delay the

remaining $1.2 B investment (depreciated over 8 years) for two years until the drug gets

approved. Only if the drug gets approved will Fosbeck proceed with the second stage investment,

which will take place in three years. The sales will commence in four years at the level of $10 B

with subsequent annual growth of 50% over the next three years, after which the sales will be

stable for another 5 years – due to delay the company will lose two years of revenues. The

probability of patent obsolescence remains the same as before – 5% each year. What is the NPV of this two-stage investment? Is the option to delay the project valuable? Explain. Pharmaset, Inc. Acquisition

The reason of the low probability of FDA approval for Fosbuvir is that another company,

Pharmaset, Inc., is working on a similar drug, called FosbuvirP, and is very close to getting FDA

approval and a patent. If Pharmaset gets a patent, Fosbeck’s own application will be denied.

Therefore, instead of developing Fosbuvir internally, Fosbeck can acquire Pharmaset. Pharmaset

already has manufacturing facilities in place and FosbuvirP is its only product. The book value of

the company’s fixed assets is $3 B, which will be depreciated using the straight-line depreciation

over the next 10 years. Pharmaset expects to receive the FDA approval and patent by the end of

this year with sales starting next year. Its next year revenues are expected to be $4 B ($10 B

revenue in case of success times the 40% probability of success) with subsequent annual growth

of 50% over the next three years, after which the sales will be stable for another 7 years. After

that the drug will lose the patent protection and its manufacturing is expected to stop. The CoGS

are expected to be 20% of revenues and SG&A expenses are $3.5 B a year if the drug is

produced and zero otherwise. In other words, in case of FDA approval Pharmaset’s revenues and

costs will be similar to Fosbeck’s, but SG&A expenses will be higher. If Fosbeck were to acquire

Pharmaset, it would be able to bring SG&A costs down to Fosbeck’s level. The probability of

FDA approval is 40% and the probability of patent obsolescence remains the same as before –

5% each year.

Mergers and Acquisitions. Target (Pharmaset) Valuation

Pharmaset’s management would be open to the sale in the valuation range of $ 20 to 24 Billion.

Please estimate Pharmaset’s value to Fosbeck, if it gets acquired.

Recommendations

Upon reviewing Fosbeck’s choices, what project(s) would you recommend?

Venture Capital Financing

Finally, to further reduce its risk Fosbeck considers to keep acquired Pharmaset as a separate

company. In this case Fosbeck will eventually shift its R&D to Pharmaset, which will continue

as a viable business even after the initial patent expires. Therefore, we can ignore the

probability of a patent becoming obsolete. However, if FDA approval is not received this year,

Pharmaset will go bankrupt, in which case its assets will be sold at residual book value.

A venture capital (VC) firm Menlo Ventures is willing to provide financing of up to $5 B in

acquisition of Pharmaset. If the VC agrees to invest in Pharmaset, it plans to exit after eight years at which time it expects

that the company’s value would be eight times its year 8 EBIT.

Menlo Ventures offers three different ways of structuring the financing:

1. Straight common stock where the VC will not receive any dividend for the first four years

and will receive 20% of NOPAT as a dividend for the remaining four years. The tax rate

for Pharmaset is 38%. In addition, the VC will receive a 20% ownership of the

company’s equity at the end of eight years.

2. Redeemable convertible debt with 10% coupon rate (interest is tax-deductible). The debt

will be converted for 15% ownership of the equity of Pharmaset at the end of eight years.

In the case of bankruptcy the debt will be immediately redeemed at its face value or at the

residual assets' book value, whichever number is lower.

3. Redeemable preferred stock with 7.5% dividend plus warrants for 15% of the equity for

an exercise price of $150 M. In the case of bankruptcy the debt will be immediately

redeemed at its face value or at the residual assets' book value, whichever number is

lower.

Which financing method should be selected by Fosbeck? Explain your answer.

Frequently Asked Questions/Helpful Hints:

Is it enough to submit Excel file?

No! The deliverable outcome is your written report to the CFO. You use Excel to support your

recommendations

Is there a minimum or maximum size of the report?

Although there is no formal minimum size of the report, it has to address all issues raised and

provide your analysis and supporting evidence. To complete the thorough analysis required for

this assignment you will probably need 3-4 pages. It is also a good idea to add a one-page

executive summary to your report.

Similarly, there is no maximum limit for the report, but please avoid adding superfluous

information to your report.

How do I set up Crystal Ball simulation?

Hint: use “Yes-No” distribution to create a binary (one or zero) variable indicating project

continuation each year. Make revenues and costs dependent values of these binary variables.

How do I explain whether the option to delay the project valuable?

Analyze the costs and benefits of making the capital investment in two steps and delaying the

project’s positive cash flows by two years and shortening the revenue stream.

Are preferred dividends tax deductible?

No, unlike coupon payments, preferred dividends are not tax deductible.

How do I decide which financing option is better?

One approach would be to see which option is less costly from Fosbeck’s management point of

view.

TUTORIAL PREVIEW

You are the senior financial analyst for Fosbeck Generic Drug Co (Fosbeck). The firm manufactures

Dated: 13th Apr'18 09:37 PM

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`Preview of Fosbeck-Generic-Drug.xlsx`

approvalprobability of Option ModificationCapEx failsExpected (today)Project rate of estimationInvestmentEBITDALess: DepreciationFCFAnalysisMACRS Automation ProjectAnnual savings cost Byproduct