BUSN3049 Corporate Finance
Question
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Questions:
You have been asked to estimate the cost of capital for Adelaide Enterprises, a company with asignificant debt load, and a depressed stock price. You have the following information:

The company has a book value of equity of $1 billion. There are 150 million shares, trading at $4/share. The unlevered beta of other companies in the same business is 1.20. The company has bank loans outstanding of $1 billion, with 5 years left to maturity and interest expenses of $40 million a year. The company currently has a CCC bond rating and has a default spread of 7% over the risk-free rate. The firm reported a net loss of -$15 million, but its operating income is expected to be $32 million next year. The risk-free rate is 3%, the equity risk premium is 5% and the marginal tax rate for all companies is 25%. Estimate the cost of capital for the company, for next year.

Adelaide Inc. is examining its dividend policy and has provided you with the following information:

 

1

2

3

Revenues

 

$1,200.00

 

$1,400.00

 

$1,600.00

Net Income

$30.00

$70.00

$160.00

Total Non-Cash WC as % of Revenues

12.00%

9.00%

6.00%

Dividend Payout

0.00%

10.00%

20.00%

The non-cash working capital currently is $150 million and the company has a cash balance right now of $50 million. In the most recent year, depreciation amounted to $75 million and capital expenditures were $125 million. You expect depreciation to grow 10% a year and capital expenditures to increase 8% a year, each year for the next 3 years.

Assuming that the company would like to double its cash balance by the end of year 3 and do a stock buyback in year 3, estimate how much cash the company will have available for its buyback.

You work for a small biotech company that has a 10-year patent for a Covid-19 vaccine that it plans to license to a larger pharmaceutical company and it has two offers:
Biogen has offered to pay $100 million today and $50 million a year, each year for the next 5 years.
Merck has offered to pay $50 million today and share 15% of net income, expected to be $400 million annually, each year for the next 10 years.

The following table lists financing costs of Biogen and Merck:

After-tax Cost of Debt Pre-tax Cost of Debt Cost of Equity Cost of Capital

Biogen                      3.75%                                      5.00%                          12.00%                     10.00%

Merck                        3.00%                                       4.00%                           9.00%                      7.50%

Which offer would create more value for you?