How does depreciation affect the MCC schedule? If depreciation were simply ignored would this affect the acceptability of proposed capital projects?
Silicon Valley Medical Technologies SIVMED was found in San Jose CA in Show more COST OF CAPITAL Directed Silicon Valley Medical Technologies SIVMED was found in San Jose CA in 1982 by Kellys OBrien David Roberts and Barbara Smalley. OBrien and Roberts both MDs were on the research faculty at the UCLA Medical School at the time; OBrien specialized in biochemistry and molecular biology and Roberts specialized in immunology and medical microbiology. Smalley who has a PhD served as department chair of the Microbiology Department at UC-Berkeley. The company started as a research and development firm which performed its own basic research obtained patents on promising technologies and then either sold or licensed the technologies to other firms which marketed the products. In recent years however the firm has also contracted to perform research and testing for larger genetic engineering and biotechnology firms and the US government. Since its inception the company has enjoyed enormous success even its founders were surprised at the scientific breakthroughs made and the demand for its services. One event that contributed significantly to the firms rapid growth was the AIDS epidemic. Both the US government and the private foundations have spent billions of dollars in AIDS research and SIVMED had the right combination of skills garner significant grant funds as well as perform as a subcontractor to other firms receiving AIDS research grants. The founders were relatively wealthy individuals when they started company and they had enough confidence in the business to commit most of their own funds to the new venture. Still the capital requirements brought on by extremely rapid growth soon exhausted their personal funds so they were forced to raise capital from outside sources. First in 1991 the firm borrowed heavily and then in 1993 when it used up its conventional debt capacity it issued $15 million of preferred stock. Finally in 1996 the firm had an initial public offering (IPO) which raised $50 million of common equity. Currently the stock trades in the over-the counter market and it has been selling at about $25 per share. SIVMED is widely recognized as the leader in an emerging growth industry and it won an award in 1998 for being one of the 100 best-managed small companies in the US. The company is organized into 2 divisions: (1) the Clinical Research Division and (2) the Genetic Engineering Division. Although the two divisions are housed in the same buildings the equipment they use and their personnel are quite different. Indeed there are few synergies between the two divisions. The most important synergies lay in the general overhead and marketing areas. Personnel payroll and similar functions are all done at the corporate level while technical operations at the divisions are completely separate. The Clinical Research Division conducts most of the firms AIDS research. Since most of the grants and contracts associated with AIDS research are long-term in nature and since billions of new dollars will likely be spent in this area the business risk of this division is low. Conversely the Genetic Engineering Division works mostly on in-house research and short-term contracts where the funding duration and payoffs are very uncertain. A line of research may look good initially but it is not unusual to hit some snag which precludes further exploration. Because of the uncertainties inherent in genetic research Genetic Engineering Division is judged to have high business risk. The founders are still active in the business but they no longer work 70-hours weeks. Increasingly they are enjoying the fruits of their past labors and they have let professional managers take over day-to-day operations. They are all on the board of directors though and David Roberts is chairman. Although the firms growth has been phenomenal it has been more random than planned. The founders would simply decide on new avenues of research and then count on the skills of the research team and good luck- to produce commercial success. Formal decision structures were almost nonexistent but the companys head start and its bright energetic founders easily overcame any deficiencies in its managerial decisions processes. Recently however competition has become stiffer and such large biotechnology firms as Genentech Amgen and even Bristol-Myers Squibb have begun to recognize the opportunities in SIVMEDs research lines. Because of this increasing competition SIVMEDs founders and board of directors have concluded that the firm must apply state-of-the-art techniques in its managerial processes as well as in its technological processes. As a first step the board directed the financial vice president Gary Hayes to develop an estimate for firms cost of capital and to use this number in capital budgeting decisions. Haves in turn directed SIVMEDs treasurer Julie Owens to have cost of capital estimate on his desk in one week. Owens has an accounting background and her primary task since taking over as treasurer has been to deal with the banks. Thus she is somewhat apprehensive about this new assignment especially since one of the board members is a well-known Northwestern University finance professor. TABLE 1 SIVMED Inc. Balance Sheet for the year ended Dec 31 1999 (in millions of dollars) Cash and marketable securities $ 7.6 Account Payable $ 5.7 Account Receivable 39.6 Accruals 7.5 Inventory 9.1 Notes payable 1.9 Current Assets $ 56.3 Current Liabilities $ 15.1 Long-term debt 61.2 Net fixed assets 114.5 Preferred stocks 15.0 Common stock 79.5 Total assets $170.8 Total claims $170.8 To begin Owens reviewed SIVMEDs 1999 balance sheet which is shown in Table 1. Next she assembled the following data: SIVMEDs long-term debt consists of 9.5 percent coupon semiannual payment bonds with 15 years remaining to maturity. The bonds last traded at a price of $891 per $1000 par value bond. The bonds are not callable and they are rated BBB. The founders have an aversion to short-term debt so the firm uses such debt only to fund cyclical working capital needs. SIVMEDs federal-plus-state tax rate is 40 percent. The companys preferred stock pays a dividend of $2.50 per quarter it has a par value of $100; it is non-callable and perpetual; and it is traded in the over-the-counter market at a current price of $ 104.00 per share. A flotation cost of $2.00 per share would be required on a new issue of preferred. (Although not planned at this time the company is interested in how the analysis would change if preferred stock had a mandatory redemption provision which specified that the firm must redeem the issue in 5 years at a price of $110 per share). The firms last dividend (D0) was $1.09 and dividends are expected to grow at about a 10 % rate in the foreseeable future. Some analysts expect the companys recent growth rate to continue others expect it to go zero as new competition enters the market but the majority anticipates that a growth rate of about 10% will continue indefinitely. An important minority of analysts have noted that over last few years the company has as a 14 % average return on equity (ROE) and has paid about 25 % of its net income as dividends. They believe the firms expected future growth rate g should be based on the information and used to estimate ks. The firms per share dividend payment over the past 5 years has been as follows: YEAR DIVIDEND 1995 $0.72 1996 0.75 1997 0.85 1998 1.00 1999 1.09 SIVMEDs common stock now sells at a price of about $25 per share. The company has 5 million common shares outstanding. The current yield on long-term T-bonds is 8% and a prominent investment-banking firm has recently estimated that the market risk premium is 6 % points over Treasury bonds. The firms historical beta as measured by several analysts who follow the stock is 1.2. The required rate of return on an average (A-rated) companys long-term debt is 10%. SIVMED is forecasting retained earnings of $1800000 and depreciation of $4500000 for the coming year. SIVMEDs investment bankers believe that a new common stock issue would involve total flotation costs including underwriting costs market pressure from increased supply and market pressure from negative signaling effects of 30%. The market value target capital structure calls for 30% long-term debt 10% preferred stock and 60% common stock. Now assume that you were recently hired as Julie Owenss assistant and she has given you the task of helping her develop the firms cost of capital. You will also have to meet with Gary Hayes and possibly with the president and the full board of directors (including the Northwestern finance professor) to answer any questions they might have. With this in mind Owens wrote up the following questions to get you started with your analysis. Answer them but keep in mind that you could be asked further questions about your answers so BE SURE you understand the logic behind any formulas or calculations you use explain your reasoning briefly. In particular be aware of potential conceptual or empirical problems that might exist write them down. QUESTIONS: What specific items of capital should be included in SIVMEDs estimated weighted average cost of capital (WACC)? Should before-tax- or after-tax values be used? Should historical (embedded) or new (marginal) values be used? Why? A) What is your estimate of SIVMEDs cost of debt? B) Should flotation costs be included in the component cost of debt calculation? Explain. C) Should the nominal cost of debt or the effective annual rate be used? Explain. D) How valid is an estimate of the cost of debt based on 15-year bonds if the firm normally issues 30-year long-term bond? If you believe the estimate is not valid what could be done to make the 15-year cost a better proxy for the 30-year cost. (Hint: Think about the yield curve). E) Suppose SIVMEDs outstanding debt had not been recently traded what other methods could be used to estimate cost of debt? F)…
