Name: Min Ouyang? Rocky Mountain Advanced Genome Inc.
Case Analysis Report Question 1: Forecast Horizon and Free Cash Flow Projections 1 Forecast Horizon In order to derive the forecast horizon, an approach of product-life cycle is used to evaluate the reasonable forecast horizon. Proper forecast horizon need to extend into the future in which the firm is under a steady-state, slow-growth or no-growth condition. By that time, the firm step into the maturity and decline period of the product-life cycle. Rocky Mountain Advanced Genome Inc.
RMAG) manufactures three different kinds of pharmaceutical products: diagnostic test kits related products which are supposed to be available in 12 months, agricultural bio-genetic engineering related products which are expected to generate revenues in 24-36 months, and human therapeutics related products which are still in the early period of research. Only after the third section of RMAG’s business enters into the slow maturity periods, should the whole company enjoy no excessive growth opportunities thus it determines the projections of the forecast horizon.The following factors might determine the length of the high-speed growth period of RMAG: the size of the company, competition advantage and the barriers for new entry. While there are pharmaceutical companies with similar business in the market, it is assumed that RMAG can only enjoy a steady growth period of 5 years after the breakthrough of the products of third section, and then the company experience another 2 years’ slow-down growth to enter into the maturity period.Since the case only provides the estimation of RMAG managements and Big Sur’s director, it is assumed that the “breakthrough” do experience in the 8th year based on the average forecast of the potential buyer and seller.
Based on above analysis, it is assumed that forecast horizon is 15 years (1996-2010). 2 Free Cash Flow Projections Since most of the data available is the evaluation from the buyer and seller ith RMAG’s optimistic and Big Sur’s sober, a reasonable assumption is to take the average value as the assumed data to perform the free cash flow projections. The following are the detail assumptions: 2. 1 Assumption on Sales revenue The sales revenue are estimated according to the sales growth rate, which are assumed separately for different segments according to its different life-circle period: introductory phase’s low growth, fast growing, reaching maturity’s sustainable growth, and declining.While the average values from the two firms are assumed to be the sales revenue for the year of 1996 to 2005, the growth rate of the following years are assumed to follow the listed principles: growth rate is assumed to stay stable in the maturity period (4 years) at a growth rate of 10%, then it is slow down till it reaches the declining period. The terminal growth rate assumption is discussed in Question 2.
2. 2 Assumption on the cost of goods sold (COGS),SG&A ,R&D,: COGS, SG&A and R&D of the year 1996-2005 are assumed to be the average rate of the estimations from RMAG and Big Sur according to the certain ratio to sales SID:310316707 Name: Min Ouyang? revenue. Since it normally enjoys a high profit margin in this industry, it is assumed that ratio decreases at a rate of 98% annually in the next 4 years in which COGS, SG&A account for slightly below 30% separately of the sales revenue. Since this data directly determine the profitability of the business, a sensitive analysis shows that the stable ratio change from 30% to 35%, the discounted free cash flow will change from -45. 46 to -58. 82 million.
2. 3 Assumptions on Contract revenue and Other incomes : The same principle of 2. is applied to assumptions of contract revenue and other incomes. 2. 4 Tax Rate: To simplify the projections of the free cash flow, an average tax rate of 40% is assumed to stay stable which is the ratio of total taxes paid to total positive incomes before taxes. 2.
5 A/R collection periods days, A/P Collection days and inventory days Although they might be different according to the different stage of the life-circle and products, it is assumed that the A/R collection periods, A/P Collection days and inventory days keep stable to be 30 days, 20 days and 40 days separately to simplify the model. . 6 capital expenditure The same principle of 2. 2 is applied to assumptions of capital expenditure from 1996 to 2005, while it witness a decrease of 90% annually in the next 4 years due to the fact that with the maturity of the business, the capital expenditure will decrease significantly comparing to the growth stage. 2. 7 Changing in non-cash item It is assumed that the non-cash items are caused by the changes of accumulated depreciations.
The depreciations are assumed to be the 10% of the up-dated noncash items which will be the sum total from the first year to date on a half-year base. . 8 Working Capital Based on the assumptions of 2. 5, the accounts receivables, the accounts payables and inventory can be calculated. The working capital is equal to accounts payable less the accounts receivables and inventory. (See attached worksheet for detail) 2.
9 WACC The assumption of WACC is assumed to match the business risks and expected inflation. Since RMAG has been found only 15 months, the commercialization of its products is expected uncertainty of FDA approval and how soon the breakthrough in research will occur. Since both RMAG and Big Sur agree that the WACC should be 0. 0, this data is assumed in the model. Meanwhile a sensitive analysis of WACC to the enterprise value shows that it can influence the outcome dramatically with a minor change from 0. 20to 0.
22 produce an outcome from 33. 85 million to negative value. Based on the above assumptions, we then calculate the PV of free cash flow with a formula of net income plus noncash items less the capital expenditure and less changing in working capital. Then we discount the FCF to get the present value of free cash flow.
(See attached table for detail) Question 2 Terminal Values and Terminal Growth Rate Issue SID:310316707 Name: Min Ouyang? A proper terminal growth rate will be assumed to proceed the calculation of the terminal value (TV). There are several ways to forecast the terminal growth rate such as the self-sustainable growth rate formula and the nominal growth model. Since it is can seldom accurately predicate the ROE and dividend policy at this early stage of the firm, an approach of the combination of real growth rate and inflation model will be used to get a reasonable growth rate. Since an inflation of 3% is generally accepted for the macro economy of USA, the problem comes to the real growth rate.For the pharmaceutics industry in its maturity, the drive of the growth will be growth of the population (0. 5%) and the increased medical expenditures.
With RMAG’s entering into the declining period of the life circle, it is reasonable to assume that the real terminal growth range will be zero growth or equal to the average real GNP growth (2. 5%). Therefore a base growth rate is 3. 5% with a fluctuate range of 3% to 5. 5%.
From the sensitive analysis, we can observe the significant influence of the terminal growth rate to the overall value in which growth change from 3% to 5. 5% leads to the 90% EV from 37. 35 to 49. 27.Perpetual growth model is the one we will examine the TV here while the general analysis of the shortcoming of some alternative ways of doing this: book value, liquidation value, multiples (P/E, P/B) is discussed below.
Book value can normally used to evaluate firms with no intangible assets and stable operations. Since book value method is backward looking, it is improper to evaluate a company like RMAG which is in its early development stage. Liquidation Value might be suitable to evaluate the firm with cloudy operating prospects. It might understate a healthy business’s terminal value like RMAG’s. Multiples will be discussed in question 3.Since TV accounts for a big portion of the Equity of the firms, sensitive analysis of its main drives such as the sales growth rate, WACC is performed.
We can clearly see the great impact of this factor in the scenario analysis. The basic assumption to calculate the TV with a perpetual growth model is listed in section 1. The formula for the terminal value of a perpetually growing firm is equal to the discounted FCF2010*(1+g) / (WACC – g). Terminal growth rate of 3. 5%, WACC of 20% with other assumptions listed in question 1 are used to calculate the TV with an outcome of 40.
92 million for the whole company in which TV is 91. million. A logical conclusion of the firm’s is a range of with the down side of 37. 45 million and 57. 17 million for the upper which separately base on the assumptions of growth rate of 3% and 5. 5% while the absolute upper limit is determined by the long run growth rate of the overall society economy.
Question 3 Multiples Analysis The possible approaches of multiples and its pros and cons are examined. Price-to-book method can be easily for calculation while it sometimes ignore the depreciation of the goods as well as the inflation factor and it always depend on the accounting practices to get the book value of the company.Other issue includes how to accurately consider the multiples of firms while firms are all different although the business might be comparable. ?SID:310316707 Name: Min Ouyang? However, it is an effective supplement to evaluate the value of the company.
It indicates in the case material that the book value of RMAG will be 3. 5 million and the firms will not pay dividends for quite a long time, so that it is assumed 3. 5 million will be the book value for RMAG. While the multiples of similar firms available are Human Genome Sciences’ 11. 71 and Myraid Genetics’ 4. 5, we take 8 times as the base assumption for the enterprise values since comparable companies are between 4 to 12 times.
The ranges of the multiples, we take 4 to 11 times as the great uncertainty of future development of the company. In this case, the 90% of the value will range from 12. 6 million to 34. 65 million as shown in the sensitive analysis.
As for another multiple of P/E, it also has some kinds of shortcoming. Firstly it cannot be accurately forecast the earnings for the maturity and declining period; anyway, it is a thing of 15 years later.Secondly it base on the earnings instead of the free cash flow, so that it might be inaccurate for predict a company like RMAG and it might be more appropriate for a mature company with stable earnings. However, it does provide us some information to predict the value of the firm. Sensitive analysis can give some clue of the range of the evaluation. We examine the net income of 2010 and get the PV of 14.
91 million with a discount rate of 20% and other assumptions listed in question 1. We then examine the relevant company’s 15-20 times for comparable companies. As for the performance of Human Genome Sciences’ 87. 7, it is high due to the fact that the company is at the stage of high growth. We take a multiple of 17 times as the base assumption and down side’s 15 and upper’s 19 to get a base value of 228.
15 million with a range of 201. 31to 254. 99million (see sensitive analysis for detail) for 90% of the value. It indicates the huge opportunities of RMAG, of course, it also contains great risks of whether or not the company can reach that period. Question 4 Triangulation of value. Different methods come to different results of the values of RMAG.
Due to the relatively short of direct operating data, all valuation is measured with inaccurate.We further investigate the assumptions contained in various approaches to triangulate the appropriate value estimation. The perpetual growth model is superior since it enjoys the features such as forward looking, cash flow-focused, time value of funds while other the pros and cons of other approaches is discussed in above section. It is reasonable to give the most weight to perpetual growth/DCF valuation, and the least weight to P/E approaching with 85%, 10% and 5% of the weight is separately allocated to perpetual growth model, P/B multiples and P/E multiples. Of ourse, if we raise the weight of P/E multiples the price will get higher due to the fact that we emphasis more on future benefits over current risks to increase the weight of P/E. Given this method of weight allocation, the attached worksheets clearly show the enterprise value (90% EV) is 48.
71 million with a range from 35. 12 million to 60. 62million based on the assumptions listed above. Beyond the purchasing decision, this outcome gives some guidelines of the negations of the acquisition activities. We could start with the price of 35.
12 million while quitting the negations if the price goes up as high as 60. 2 million. ?SID:310316707 Name: Min Ouyang? Income Statement Forecast Income Statement 1996 1997 1998 1999 2000 2001 2002 =H50 =H8*H49 =I50 =I8*I49 =J50 =J8*J49 =K50 =K8*K49 =L50 =L8*L49 =M50 =M8*M49 =N50 =N8*N49 =O50 =O8*O49 =P50 =P8*P49 Total Expenses Other Income Income before Taxes =B14+B15
