Question 5 Roscor Pharmaceuticals anticipates earnings of $539 million every yea

Question

Question 5

Roscor Pharmaceuticals anticipates earnings of $539 million every year from now on if it simply maintains its current portfolio of assets and declines any new projects. But the firm is approached by an arthritis therapy company with an opportunity for Roscor to invest $35 million today; $175 million one year from now; and $55 million two years from now in a new product that requires technical development and FDA approval. The new investment will generate annual after-tax earnings of $68 million in perpetuity starting three years from today. Roscor has 150 million shares outstanding and the required rate of return on the stock is 11%.

a) What is the price of one Roscor share (the share price) if it continues “business as usual” and turns down the investment opportunity?

b) What is the total dollar present value of the investment?

c) What is the total dollar present value of the benefit of the new income stream?

d) What would Roscor’s new stock price be if it made the investment?

Explanation / Answer

a) Present Value of constant perpetuity = C/R where C = constant earnings/cash flow i.e $539; R = Rate of return i.e 11%

Present value of constant perpetuity = $539 million/11% = $4,900 million

No. of shares outstanding = $150 million

Price of one share = $4,900/150 = $32.67

(b) Total dollar present value of the investment = $35 million/(1+0.11)0 +$175 millon/(1+0.11)1 +$55 million/(1+0.11)2

     Value of perpertuity after 3 years = $68million/11% = $618.18 million

     Present value of $618.18 million = $618.18 million/(1+0.11)3 = $618.18 million/1.368 = $451.89 million

    Hence, total dollar present value of the benefit of the new income stream is $451.89 million

(d) New stock price = (Present value of benefit - present value of investment)/No. of outstanding shares = $451.89 - 237.3 /150 = $214.59 million / 150 million = $1.431

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