Assignment

Questions

Question 1 You are the CFO of a major pharmaceutical firm. You are evaluating a proposal for a new project which would use genetic engineering methods to develop new drugs for the treatment of tuberculosis. Starting up this project would require a single initial investment of $100 million today, and no additional investment. You estimate the expected cash flows from the project would be zero in years 1-6. In year 7, the expected cash flow would be $15 million, and the expected cash flows would then grow from this level at a rate of 6% forever. The risk-free rate is 5% per year, and the expected return on the market is 15% per year. Assume that the CAPM holds and ignore taxes. All cash flows and discount rates are in nominal terms.

Determine whether your firm should undertake this project under each of the following (mutually exclusive) scenarios. So, for example, for scenario B you should use only the information in scenario B, and not the information from scenarios A and C.

Scenario A Your firm's beta is 1.4. The beta of the genetic engineering project, if you undertake it, would be 0.8.

Scenario B You identify two firms whose only projects are genetic engineering projects equivalent in risk to the project you are analyzing, so the beta of the new genetic engineering project, if you undertake it, would be the average of the betas of these two firms (call them firm X and firm Y). According to your information, firm X and firm Y have equity betas of 1.2 and 1.5, debt betas of 0.2 and 0.4, and debt-to-equity ratios of 0.55 and 1.5, respectively. Your firm's beta is 1.6, and your firm is entirely equity financed.

Scenario C Your firm's beta is 1.6, and your firm is entirely equity financed. You can't identify a firm with a single project similar to the genetic engineering project you are analyzing. However, you do identify two purely equity financed firms C and D. Firm C has two divisions. Division 1 has a genetic engineering project equivalent in risk to your new project and no other projects, so the beta of division 1 should be the same as the beta of the new genetic engineering project, if you undertake it. Division 2 has a high volume drug production project very different in risk. The market values of divisions 1 and 2 are $100 million and $600 million, respectively, and the equity beta of Firm C is 1.5. Firm D has a single division with a high volume drug production project equivalent in risk to Firm C's second division. Firm D has an equity beta of 1.6.