**Major Project Report – Fosbeck Generic Drug Co**

**Executive Summary**

The company intends to undertake three projects; the first project is to invest in a fully automated bioreactor machine complex to automate its drug manufacturing. The second project involves the development of a new drug for the treatment of Hepatitis C; the project will involve the approval of the FDA to start selling. Since the probability of approving the second project by the FDA is only 10%, Fosbeck Generic Drug Co intends to acquire Phamaset Inc. because it is working on a similar drug and it is almost getting approved by the FDA. The application of Fosbeck will be denied if Pharmaset gets the patent for producing and selling FosbuvirP. Investment appraisal techniques are used to evaluate and analyze the viability of the major projects. NPV is an investment measurement tool used to determine whether the projects will result in income or losses. IRR measures the profitability of the projects in percentage terms. IRR of the project must be greater than the required rate of return to get a positive NPV.

**Investment appraisal**

**Automation Project**

The automation of the company’s manufacturing will benefit the company in a way that it will save $50 million in annual labor costs, and $10 million in waste costs, and generate $80 million annually from the sale of waste products. The NPV of the project at a discounting rate of 12% is $1.37 million, and the IRR is 12.10%. The decision rule of NPV states that a project should only be accepted if it has a positive NPV and rejected if it has a negative NPV.

Based on the NPV, the company should purchase the automated bioreactor machine. IRR decision method is compared to the project’s required rate of return. The decision rule of IRR only allows the management to undertake the project if its IRR is greater than the discounting rate. A higher IRR implies that the estimated cash flows of the project can cover all the costs and generate some income. IRR of the project is greater than the required rate of return of the project. Thus, the company should purchase the machine. NPV and IRR decrease with an increase in the level of sales of the by-product. When the sale of byproduct is decreased by 10%, 30%, and 50%, NPV becomes positive, IRR reduces to less than the project’s required rate of return and the expected NPV is negative.

**Fosbuvir Project**

The project involves the development of a new drug to treat Hepatitis C. The project will attract a development cost of $600 million in the first year and $2 billion in CapEx next year. The company will start selling the product in two years after receiving approval from the FDA. With the probability of approval of 10%, the NPV of the project is $8.59 billion, and the IRR is 31.52%; this implies that the project is profitable since the NPV is positive and the IRR is greater than the required rate of return. If the project is accepted, NPV will increase to $75.16 billion, and IRR will be 96.59%; this implies that the project can break even as all the costs incurred will be fully recovered. If the FDA fails to approve the project, the company will incur a loss of $600 million, and this means that the project will fail. The company should delay the project until approved because the NPV of delaying the project is greater than the NPV of starting the project in 2 years.

**Pharmaset, Inc. Acquisition**

The probability of the FDA approving the product for Pharmaset, Inc. is high. This means that there is a high chance that the FDA may not approve the product for Fosbeck. If Fosbeck has to acquire the company as soon as the product is approved to it, then it must pay for its assets which have a book value of 3 billion. The assets are depreciated on a straight-line basis over 10 years. The probability of the FDA approving the project to Paharmaset is 40%. From the Excel calculations, the value of Pharmaset is $21.26 billion, less than the valuation range proposed by Pharmaset’s management. Therefore, Fosbeck should acquire the company at 21.26 billion.

Fosbeck should automate its manufacturing by purchasing the automated bioreactor machine; this is because the investment has a positive NPV and an IRR greater than the project’s required rate of return. However, the company should not invest in the new product but rather acquire Pharmaset since the probability of the FDA approving the product to Pharmaset is very high. Moreover, the value of purchasing the company is lower compared to the terminal value of the project.

**Venture Capital Financing**

Failure to approve the product by the FDA will land Pharmaset into Bankruptcy, and as a result, its fixed assets will be sold at residual book value. Menlo Venture is willing to invest in the company for 8 years and provide funding up to 5 billion in the acquisition. The company will structure the financing in equity form, debt, and preference share capital. From the analysis, convertible debt is the best option since it results in the highest NPV than equity financing and redeemable preference capital. Equity financing attracts a dividend payment for 20% of NOPAT from year 5 to year 8, while redeemable preferred has a 7.5% dividend plus 15% warrant of equity. Convertible debt financing is the best because the company will benefit from the interest tax shield.

You are the senior financial analyst for Fosbeck Generic Drug Co (Fosbeck). The firm manufactures and sells generic over-the-counter drugs in plants located throughout the country. You have been asked to generate some answers to questions emanating from the Board of Directors. These questions can be grouped into two broad categories – what projects to choose for the near future and how to finance these projects.

**Deliverable:**

Please present your recommendations in a report written for your supervisor, the firm Controller. Clearly show your analysis and communicate your conclusions and recommendations. Support your report by calculations in the Excel spreadsheets. In your report, explain the results of each portion of your analysis (represented by the tabs on the Excel template). Submit all the completed Excel worksheets with the completed responses to the questions posed to support your report and recommendation.

**Steps to Completion:**

##### Individual Project Analysis

Your first task is to analyze the company’s three projects and provide your recommendations about their implementation.

**Automation project**

One of Fosbeck’s plants is trying to decide whether to automate its drug manufacturing by purchasing a fully automated bioreactor machine complex.

The proposed machine costs $500 M and it will have a five-year anticipated life and will be depreciated by using the 3-year MACRS depreciation method toward a zero salvage value. (MACRS depreciation rates are: Year 1: 33%, Year 2: 45%, Year 3: 15% and Year 4: 7%) However, the plant will be able to sell the machine in the after-market for 25% of its original costs at the end of year 5. The firm estimates that the installation of the bioreactor will bring annual cost savings of $50 M from reduced labor costs, $10 M per year from reduced waste disposal costs, and $80 M per year from the sales byproduct of the bioreactor process net of selling expenses. Fosbeck requires a 12% return from its investment and has a 21% marginal tax rate.

__Decision Criteria – NPV and IRR__

- Calculate the NPV and IRR for the project.
- The manager of the plant raised some concerns about the revenues from the byproduct sale. He projects that the price of the byproduct in year 1 and the following years could be 10% to 50% less than what was projected. However, the savings from reduced labor costs and reduced waste disposal costs would remain the same. He presented the following probability distribution on the projected reclaimed plastic sales:

Remain same as projected 40%

Decrease by 10% 30%

Decrease by 30% 20%

Decrease by 50% 10%

Estimate the NPV and IRR for each of these scenarios. Estimate the expected NPV.

__Break-even Analysis__

- At what volume of byproduct sales would Fosbeck have a break-even NPV=0?

**Fosbuvir Project**

The company is considering the development of a new drug to treat Hepatitis C, code-named the Fosbuvir Project. Fosbeck has already spent $420 M on preliminary research for drug development and it will need another $600 M on development this year (tax-deductible) and $2 B in CapEx next year (these cash outlays are not part of the cash flows that you have estimated earlier, because this project is not approved yet). Capital expenditures will be depreciated over 10 years using straight-line depreciation.

The patent for the drug is pending and the company expects to receive an FDA approval and start selling the drug in two years. **If approved**, revenues in the first year of sales are $10 B with subsequent annual growth of 50% over the next three years (until the fourth year of sales), after which the sales will be stable between the fourth and the tenth years of sales. After that the drug will lose patent protection and its manufacturing is expected to stop. The CoGS is estimated to be 15% of revenues and SG&A expenses are $2 B a year if the drug is produced and zero otherwise.

**Expected** revenues and expenses should take into account the uncertainty of getting the patent and FDA approval. The company estimates the probability of getting the approval in two years is 10% (i.e., if the company gets the approval the revenue is $10 B, if it does not, the revenue is zero, which makes the **expected** revenue in the first year of sales equal to $1 B). Even if Fosbuvir gets approved by the FDA, each year there is a 5 % probability of the patent becoming obsolete due to a new drug entering the market, in which case the revenues, as well as CoGS and SG&A expenses, will drop to zero.

__NPV and IRR__

- Estimate expected revenues and costs, taking the probability of approval and the probability of the patent becoming obsolete into account
- Please estimate the NPV and IRR of the Fosbuvir Project, using the company’s WACC of 12%.

__Real Option__

One of your colleagues pointed out that instead of starting construction before the FDA approval, the company can invest only $0.8 B next year (depreciated over 10 years) and delay the remaining $1.2 B investment (depreciated over 8 years) for two years until the drug gets approved. Only if the drug gets approved will Fosbeck proceed with the second stage investment, which will take place in three years. The sales will commence in four years at the level of $10 B with subsequent annual growth of 50% over the next three years, after which the sales will be stable, but due to delay the company will lose **two years** of revenues. The probability of patent obsolescence remains the same as before – 5% each year.

- What is the NPV of this two-stage investment?

Two-stage investment alternative can be evaluated by simply calculating the NPV for two different outcomes (FDA approval or not) and then finding the expected value. Alternatively, a Monte Carlo simulation can be used (see below). To check your calculations look at the expected NPVs found using these two approaches – they should be nearly identical.

- Is the option to delay the project valuable? Explain.

__Monte Carlo Simulation (extra credit 5%) – ATTENTION! This part is completely optional__

You want to evaluate the Fosbuvir Project using Monte Carlo simulation (see the template) based on the probability of FDA approval in two years and patent obsolescence in each subsequent year. You can either use Crystal Ball or you are welcome to use any other software, including the Random Data generator in Data Analysis Pack.

- What is the probability of a positive NPV?
- Please discuss the riskiness of the project.

**Pharmaset, Inc. Acquisition**

The reason for the low probability of FDA approval for Fosbuvir is that another company, Pharmaset, Inc., is working on a similar drug, called FosbuvirP, and is very close to getting FDA approval and a patent. If Pharmaset gets a patent, Fosbeck’s own application will be denied. Therefore, instead of developing Fosbuvir internally, Fosbeck can acquire Pharmaset. Pharmaset already has manufacturing facilities in place and FosbuvirP is its only product. The book value of the company’s fixed assets is $3 B, which will be depreciated using straight-line depreciation over the next 10 years. Pharmaset expects to receive the FDA approval and patent by the end of this year with sales starting next year. Its next year revenues are **expected** to be $4 B ($10 B revenue in case of success times the 40% probability of success) with subsequent annual growth of 50% over the next three years (until the fourth year of sales), after which the sales will be stable until the tenth year of sales. After that the drug will lose patent protection and its manufacturing is expected to stop. The CoGS are expected to be 15% of revenues and SG&A expenses are $3.5 B a year if the drug is produced and zero otherwise. In other words, in case of FDA approval Pharmaset’s revenues and costs will be similar to Fosbeck’s, but SG&A expenses will be higher. If Fosbeck were to acquire Pharmaset, it would be able to bring SG&A costs down to Fosbeck’s level. The probability of FDA approval is 40% and the probability of patent obsolescence remains the same as before – 5% each year.

__Mergers and Acquisitions. Target (Pharmaset) Valuation__

Pharmaset’s management would be open to the sale in the valuation range of $ 22 to 26 Billion.

- Please estimate Pharmaset’s
**value to Fosbeck**, if it gets acquired.

**Recommendations**

Upon reviewing Fosbeck’s choices, what project(s) would you recommend?

**Venture Capital Financing**

Finally, to further reduce its risk Fosbeck considers keeping acquired Pharmaset as a separate company. In this case, Fosbeck will eventually shift its R&D to Pharmaset, which will continue as a viable business even after the initial patent expires. **Therefore, we can ignore the probability of a patent becoming obsolete**. However, if FDA approval is not received this year, Pharmaset will go bankrupt, in which case its fixed assets will be sold at residual book value.

A venture capital (VC) firm Menlo Ventures is willing to provide financing of up to $5 B in the acquisition of Pharmaset.

If the VC agrees to invest in Pharmaset, it plans to exit after eight years at which time it expects that the company’s value would be eight times its year 8 EBIT.

Menlo Ventures offers three different ways of structuring the financing:

- Straight common stock where the VC will not receive any dividend for the first four years and will receive 20% of NOPAT as a dividend for the remaining four years. The expected tax rate for Pharmaset is 21%. In addition, the VC will receive a 20% ownership of the company’s equity at the end of eight years. In the case of bankruptcy, 20% ownership of the company’s equity will apply to the book value immediately
- Redeemable convertible debt with 10% coupon rate (interest is tax-deductible). The debt will be converted for 15% ownership of the equity of Pharmaset at the end of eight years. In the case of bankruptcy, the debt will be immediately redeemed at its face value or at the residual assets’ book value, whichever number is lower.
- Redeemable preferred stock with a 5% dividend plus warrants for 15% of the equity for an exercise price of $150 M. In the case of bankruptcy the debt will be immediately redeemed at its face value or at the residual assets’ book value, whichever number is lower.

Which financing method should be selected by Fosbeck? Should it accept Menlo Ventures’ offer? Explain your answer.

**Frequently Asked Questions/Helpful Hints:**

#### Is it enough to submit an Excel file?

No! The deliverable outcome is your written report to the CFO. You use Excel to support your recommendations

#### Is there a minimum or maximum size of the report?

Although there is no formal minimum size of the report, it has to address all issues raised and provide your analysis and supporting evidence. To complete the thorough analysis required for this assignment you will probably need 3-4 pages. It is also a good idea to add a one-page executive summary to your report.

Similarly, there is no maximum limit for the report, but please avoid adding superfluous information to your report.

#### How do I set up a Crystal Ball simulation?

Hint: use a “Yes-No” distribution to create a binary (one or zero) variable indicating project continuation each year. Make revenues and costs dependent values of these binary variables.

#### How do I explain whether the option to delay the project is valuable?

Analyze the costs and benefits of making the capital investment in two steps delaying the project’s positive cash flows by two years and shortening the revenue stream.

#### Are preferred dividends tax deductible?

No, unlike coupon payments, preferred dividends are not tax deductible.

#### How do I decide which financing option is better?

One approach would be to see which option is less costly from Fosbeck’s management point of view.