A Medical Company Has Contracted You As A Finance Consultant

A Medical Company Has Contracted You As A Finance Consultant To Advise

A medical company has contracted you as a finance consultant to advise them on an investment opportunity of marketing their new drug “Memory”, treating Alzheimer disease. More specifically, the company wants you to advise them on whether to make the investment or not and whether it is preferable to use equity or debt financing for the project. Information about the company and the investment opportunity follows:

General Information

- The company is currently financed by 60% equity and 40% debt.

- The current after-tax WACC is 9%.

- The cost of company debt, Rd, is 5% and expected to remain constant as long as D/E ≤ 0.8.

- If D/E exceeds 0.8, Rd increases by 1% for each additional 0.1 increase in D/E. For example, D/E between 0.8 and 0.9 implies Rd=6%.

- The corporate tax rate, Tc, is 25%.

- The analysis is set as of January 1, 2013.

The Investment Opportunity

- The initial cost of marketing the investment is provided (though the specific amount is not given here).

- The project is expected to generate annual cash flows of a specified amount (not specified here) at the end of each year for 5 years, starting December 31, 2013.

- After five years, the investment has no scrap value.

- The company can finance the project either with 75% debt and 25% equity or with 60% equity and 40% debt.

- Under the 75% debt financing option, debt remains fixed throughout the project’s duration.

- The upfront costs are $0.07 per dollar of equity issued and $0.01 per dollar of debt issued.

- There are no costs associated with rebalancing debt.

Your Task

Create a detailed spreadsheet model in Microsoft Excel to analyze whether the company should undertake the investment and, if so, which financing alternative it should choose. Specifically, the spreadsheet should include the following analyses:

1. Evaluate the viability of financing the investment entirely with equity.

- Calculate the investment’s worth to the company using the appropriate valuation methods, considering all relevant cash flows and costs.

2. Determine the interest tax shield for each financing alternative.

- Compute the present value (PV) of the interest tax shield for both the 75% debt/25% equity scenario and the 60% debt/40% equity scenario, using appropriate discount rates.

3. Apply the Adjusted Present Value (APV) method to compare the total value of each financing option.

- The APV is calculated as the base-case NPV of the project plus the PV of financing side effects (interest tax shields).

- The model should clearly indicate which financing alternative is preferable based on the calculations.

Important Notes

- Use cell references in your formulas to enable future updates of the model.

- Clearly document assumptions, formulas, and decision points within the Excel model.

- The analysis should be comprehensive enough to support strategic decision-making about the investment and optimal financing structure.

Deadline

The complete Excel model and analysis are required within 7 days of receipt.

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Paper For Above instruction

Introduction

Financial decision-making in corporate environments, especially in the context of investment appraisal and capital structure, requires rigorous quantitative analysis. The case of a medical company's potential marketing investment for a new drug targeting Alzheimer’s disease presents a complex scenario involving valuation, tax shields, and optimal financing decisions. This paper aims to provide a comprehensive assessment, employing valuation techniques including NPV and APV, to advise the company on whether to proceed with the investment and which financing structure to adopt.

Evaluating the Investment with an Equity-Only Financing Approach

The initial step involves determining the worth of the investment if financed solely through equity. The valuation process starts with estimating the project's free cash flows, discounted at an appropriate rate reflecting the firm's cost of equity or the project-specific discount rate. Given the initial data—cash flows, investment cost, and project duration—the net present value must be calculated to ascertain whether the project adds value to the firm.

The base-case valuation considers the present value of the future cash flows discounted at the company's WACC if the project is financed similarly to the company’s existing capital structure. Since the current WACC is 9%, and the firm's equity constitutes 60%, we can approximate the project’s net worth by calculating the net present value of the expected cash flows, subtracting the initial marketing cost, and adjusting for the cost of issuing additional equity.

Mathematically, the NPV with equity-only financing is computed as:

\[ \text{NPV}_\text{equity} = \sum_{t=1}^5 \frac{\text{Cash Flow}_t}{(1 + \text{WACC})^t} - \text{Initial Cost} - \text{Equity Issuance Cost} \]

where the issuance cost is $0.07 per dollar of new equity issued. The decision criterion is whether \(\text{NPV}_\text{equity} > 0\); only then considering the project worthwhile.

Calculating the Interest Tax Shield

The interest tax shield (ITS) is the tax saving resulting from deductibility of interest payments on debt. For each financing structure, the PV of the ITS significantly influences the project value. Each alternative’s ITS is calculated based on the debt amount and the cost of debt, adjusted for corporate tax rate, and discounted at the cost of debt or an appropriate rate reflecting the debt’s risk.

For the 75% debt/25% equity scenario:

- The annual interest expense is \(D \times R_d\),

- The present value of tax shields is calculated as the sum of the discounted tax savings over the project period.

Similarly, for the 60% debt/40% equity case:

- The same calculation is followed with the respective debt level and interest rate \(R_d\).

Given the firm’s tax rate of 25%, the annual interest tax shield is:

\[ \text{Interest Tax Shield} = \text{Interest Expense} \times T_c \]

and discounted at the cost of debt or a relevant rate, including adjustments for the increase in Rd as D/E exceeds 0.8.

Applying the APV Method for Final Decision

The APV combines the base-case NPV of the project (assuming all-equity financing) with the PV of the financing side effects, primarily the interest tax shield. For each financing structure:

- Calculate the base-case NPV considering the cash flows and initial costs.

- Compute the PV of the interest tax shield.

- Sum these to obtain the APV.

The financing alternative yielding the higher APV is the optimal choice, guiding the company's decision to fund the project and select the appropriate capital structure.

Conclusion

The comprehensive analysis incorporating valuation, the tax shield's valuation, and APV adjustment offers robust insights. If the equity-only NPV is positive, the project can be pursued, with the financing structure optimized for value maximization. Based on the sensitivity of interest rates and debt levels, the model should guide the company in adopting a capital structure that maximizes corporate value while acknowledging the risks associated with increasing leverage.

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