Medical Company Contracts You As Finance Consultant

A Medical Company Has Contracted You As A Finance Consultant To

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 weighted average cost of capital (WACC) is 9%. The company's cost of debt (Rd) is 5%, expected to remain constant as long as the debt-to-equity ratio (D/E) is less than or equal to 0.8. Beyond that, Rd increases by 1% for each additional 0.1 increase in D/E. The corporate tax rate (Tc) is 25%. The current date is January 1, 2013.

The investment opportunity:

The initial marketing cost is specified (but the exact amount is missing in the prompt). The project is expected to generate annual cash flows of a certain amount ($) at the end of each year for five years, beginning December 31, 2013. After five years, the project has no salvage 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 scenario, the debt level remains fixed over the project's duration. The upfront issuance costs are $0.07 per dollar of equity issued and $0.01 per dollar of debt issued, with no cost for rebalancing the debt during the project.

Your task:

Create a spreadsheet model (using Microsoft Excel) that evaluates the investment decisions and financing options:

a) Calculate whether it would be worthwhile to finance the investment with equity only, showing the investment’s worth to the company.

b) Calculate and present the present value of the interest tax shield for each financing alternative.

c) Use the Adjusted Present Value (APV) method—base-case NPV plus the present value of financing side effects—to determine which financing method the company should prefer, based on the provided data.

The spreadsheet should employ cell references for all formulas related to these tasks, making it suitable for future use by the company.

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Paper For Above instruction

In evaluating the investment opportunity of marketing a new drug (“Memory”) to treat Alzheimer’s disease, the company must consider multiple financial factors that influence decision-making, notably the project's potential profitability, tax benefits from debt financing, and optimal capital structure. A comprehensive financial analysis involves calculating the project's net present value (NPV) under different financing assumptions, understanding the value of tax shields afforded by debt, and applying the APV framework to isolate the effects of capital structure. This paper discusses these components in detail, providing insights into whether the project should be undertaken and how it should be financed, based on financial principles and current data.

Investment Worth and Decision Criteria

The initial step involves assessing whether the project adds value to the company when financed solely through equity. Assuming the project's future cash flows are known and discounted at the appropriate cost of equity, the company's willingness to undertake the project hinges on the project's net contribution to firm value. Given the cash flows of a specified amount annually for five years, the present value calculation considers the appropriate discount rate, which, if financed fully by equity, equals the company's unlevered cost of equity.

Since the initial sales of the drug are expected to generate repetitive cash flows, the project's valuation relies heavily on the discount rate commensurate with its risk profile. If the project’s net present value, calculated by discounting cash flows at the company’s unlevered cost of equity, is positive, it indicates the project’s worth to the company. Conversely, a negative NPV suggests that the project would diminish the firm's value and should be avoided.

Tax Shield Valuation and Its Significance

Debt financing offers a tax shield—an advantage due to the tax deductibility of interest payments—that increases a project's overall valuation. The interest tax shield's value depends on the amount of debt, the interest rate, and the corporate tax rate. Its present value is obtained by discounting these shields at the cost of debt or the company's WACC, depending on the context.

In the scenario of a fixed debt level, the interest tax shield can be viewed as a steady cash flow that can be discounted at the debt cost rate. Under the two financing options—75% debt and 25% equity versus 60% debt and 40% equity—the magnitude of the tax shield varies because of differential debt levels. Calculating the PV of these shields involves projecting the annual interest expense and discounting appropriately, factoring in the fixed debt level under the chosen financing structure.

The APV Method and Comparative Analysis

APV separates the valuation of the unlevered project from the benefits of financing. It starts with the base-case NPV assuming no debt (all equity financing) and then adds the PV of the interest tax shield or other financing side effects. This approach makes explicit the impact of leverage and financing choices, allowing a better comparison between financing alternatives.

Using the APV method involves calculating the base-case NPV considering the project's cash flows discounted at the unlevered cost of equity. Next, the PV of the tax shield is added, which entails discounting the tax shield cash flows at the cost of debt. Comparing the total APV across options reveals which financing structure enhances firm value more effectively. The optimal choice balances the benefits of the tax shield against the costs of increased debt.

Practical Implications and Recommendations

Applying these financial models enables the company to decide whether the project adds value under different financing paradigms and choose the optimal capital structure. If the project’s standalone value exceeds the costs of issuing new equity, and if the tax shield advantage outweighs potential financial distress costs, debt financing may be preferable. Conversely, if the project’s cash flows are uncertain or highly risky, maintaining a conservative debt level minimizes potential downsides. The decision hinges on precise calculations integrating cash flow forecasts, cost of capital estimates, and tax considerations, all systematically modeled within Excel.

Conclusion

The investment decision regarding the “Memory” drug involves multiple financial considerations. Employing techniques such as calculating the project's NPV, estimating the value of interest tax shields, and applying the APV approach provides a structured framework to inform whether the project should proceed and how it should be financed. These quantitative analyses guide the company toward maximizing value while managing financial risks, ultimately supporting strategic capital structure decisions aligned with firm valuation goals.

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