Medical Company Investment And Financing Analysis

Medical Company Investment Analysis and Financing Decision

A medical company has contracted you as a finance consultant to advise them on the investment opportunity related to marketing a new drug “Memory”—treating Alzheimer’s disease. Specifically, the company seeks your expertise in determining whether to proceed with the investment and to evaluate the optimal financing approach—either equity or debt. You are tasked with developing a comprehensive spreadsheet model in Microsoft Excel that analyzes the project’s viability and financing implications based on provided financial parameters and scenarios.

The company’s current financial structure is 60% equity and 40% debt, with an after-tax weighted average cost of capital (WACC) of 9%. The cost of company debt (Rd) is 5%, remaining constant until the debt-to-equity ratio (D/E) surpasses 0.8, after which Rd increases by 1% for each additional 0.1 (ten-percentage-point) increase in D/E. The corporate tax rate is 25%, and the investment analysis begins on January 1, 2013.

The investment opportunity involves an initial marketing cost (specified amount), producing annual cash flows of a specified amount over five years, with no residual or scrap value afterward. The company is contemplating two financing options: one with 75% debt and 25% equity, and another maintaining 60% equity and 40% debt. Under the 75% debt scenario, the debt remains fixed during the project’s duration. Additionally, issuance costs are $0.07 per dollar of equity and $0.01 per dollar of debt, with no costs associated with rebalancing debt.

Assignment Tasks

Your task is to create an Excel spreadsheet model that performs the following analyses:

  1. Determine whether it is worthwhile for the company to finance the investment solely with equity by calculating the project's worth to the company.
  2. Calculate the present value (PV) of the interest tax shield for each financing alternative.
  3. Implement the Adjusted Present Value (APV) method by combining the base-case NPV with the PV of financing side effects to determine which financing approach is preferable given the provided data.

You must use cell references in your formulas to ensure the model is dynamic and adaptable for future analysis. The spreadsheet should explicitly show your calculations and assumptions for transparency and decision-making clarity.

Paper For Above instruction

In this analysis, we examine whether the medical company should proceed with its investment in marketing a new Alzheimer’s drug and which financing method—equity or debt—is optimal. This entails constructing a detailed financial model incorporating the project's cash flows, costs, and the impact of various financing structures, all while considering tax shields, issuance costs, and the weighted average cost of capital. The goal is to provide a comprehensive recommendation based on rigorous valuation methods, primarily the APV approach, integrating the benefits of debt-related tax shields with the base-case NPV.

Introduction

Investment decisions in the pharmaceutical industry are complex due to high R&D costs, uncertain cash flows, and the strategic importance of financing choices. For this reason, financial analysts employ valuation techniques like NPV and APV to evaluate the potential viability of projects and the optimal capital structure. The company’s current mix of 60% equity and 40% debt provides a benchmark, but evaluating alternative financing strategies could reveal opportunities to enhance firm value, especially through tax shields derived from debt financing.

Financial Parameters and Assumptions

The company's present financial parameters form the foundation for modeling. The 9% WACC reflects the overall cost of capital based on existing funding sources, while the debt component's cost (Rd) varies based on leverage ratios. Ignoring the initial investment cost for the sake of the model will be overridden in actual calculations; in practice, the initial investment figure would be added explicitly. The cash flow projections are projected for five years, and the tax rate of 25% influences the valuation of the interest tax shield.

Methodology and Valuation

The analysis focuses on three key components:

  1. Equity-only funding worth: This involves calculating the project's net present value (NPV) assuming the entire investment is financed through equity, which entails using the company's cost of equity as the discount rate. The initial equity investment plus issuance costs, as well as projected cash flows, are factored into this calculation.
  2. Interest Tax Shield (ITS): The tax shield value results from the deductibility of interest payments. For each financing mix, the annual interest expense is computed based on the debt level and cost of debt; then, the PV of the tax shield is calculated using the appropriate discount rate—generally, the cost of debt or WACC—taking into account the timing and magnitude of interest payments.
  3. APV Calculation: The APV method entails calculating the base-case NPV (assuming all equity financing), then adding the PV of the tax shield and subtracting the issuance costs. This segregates the effect of financing from the project's core value, providing a clearer picture of the value added by debt through the tax shield.

Implementation in Excel

In building the Excel model, you will create cells for input parameters such as project cost, cash flows, financing ratios, issuance costs, and tax rate. Formulas will reference these cells to compute the project's NPV under different scenarios, the interest tax shields, and the final APV. Key cells include the discount rate, debt and equity amounts, interest expenses, and PV calculations.

For example, the PV of the tax shield for the 75% debt scenario can be computed as:

=PV(discount_rate, number_of_years, interest_tax_shield_payments)

where the annual interest expense is:

=Debt_amount * Rd

with Rd adjusted according to leverage ratios. Issuance costs are factored into the initial cash flow adjustments, reducing the net proceeds from issuance.

Discussion and Recommendations

After performing the calculations, the model will show whether undertaking the project is value-enhancing and whether leveraging through debt adds sufficient value via tax shields to justify potential financial risks. If the APV for the 75% debt structure exceeds that of the 60% equity-financed approach, it supports increasing leverage, provided the company's risk appetite aligns. Conversely, if the equity-only scenario yields higher value, the company should avoid additional debt.

Conclusion

This comprehensive financial modeling and valuation exercise facilitate informed decision-making, balancing project prospects with capital structure implications. Employing the APV approach enables the company to isolate and quantify the benefits of debt financing, mainly secured through tax shields, while also considering costs of issuance and potential financial risk. The outcome provides strategic guidance on the preferred financing path, ensuring maximum firm value creation in pursuit of its new drug marketing initiative.

References

  • Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2013). Corporate Finance. McGraw-Hill Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Damodaran, A. (2012). Corporate Finance: Theory and Practice. Wiley.
  • Graham, J. R., & Harvey, C. R. (2001). The Theory and Practice of Corporate Finance: Evidence from the Field. Journal of Financial Economics, 60(2-3), 187-243.
  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261-297.
  • Myers, S. C. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, 5(2), 147-175.
  • Shapiro, A. C. (2011). Multinational Financial Management. Wiley.
  • Grossman, S. J., & Van Huyck, J. (1988). Sunk Costs and Innovator Incentives. The Journal of Economics, 76(1), 29-51.
  • Fama, E. F., & French, K. R. (2002). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 16(3), 25-46.

Related Assignments