* Introduction of Pharmacyclics (PCYC)
Focused on improving treatment of cancer, atherosclerosis and retinal disease, PCYC is a small pharmaceutical company which often licensed compounds to larger ones to bring drugs to market. PCYC had developed four new drugs in pipeline, among which Xcytrin was the most promising one and was expected to gain FDA’s approval in 2002. Facing with substantial R&D costs, PCYC had constantly searching for funds to finance the expenses since start-up.
* Historical funding decisions
Before IPO, PCYC managed to finance the company with the help of its own money and outside investors, mainly venture capitalists, in the form of convertible preferred ...view middle of the document...
The second factor was valuation. PCYC stock was high and Miller felt that the market price incorporated a substantial probability that Xcytrin would not successfully complete the FDA approval process. Miller should decide whether to take this advantage of pricing opportunities.
* Cash flow projections
The after-tax cash flow through 2002, assuming Xcytrin and Lutrin are approved, can be seen from Exhibit 1.
If the drugs were not approved, there would be no contract revenue from 2002. Company can only make $1million every year from the license & grant revenue.
To see how many future years of funding PCYC had, we require that the summation of its operating cash flow and liquid assets in the previous year should be sufficient to cover its R&D as well as G&A expense in the next year. PCYC had liquid assets of 106 million which can be converted into cash within a short time as well as long-term investments with maturity through 2001,. Whenever there is not enough cash flow, liquid asset is used to fill the gap.
In Exhibit 2, we see that although PCYC’s operating cash flow remained negative from FY00 to FY02, it was able to sustain the RD&GA expenses with liquid assets and long term investment which matured in FY01. Till the end of FY02, PCYC had remaining liquid assets of 4886 thousand dollars, together with its cash flow, but it was insufficient to support the 97 million dollars expenses in FY03.
After projecting the profits that Xcytrin and Lutrin may generate if approved, given the assumptions offered, we try to calculate the expected cash flows for PCYC up until the expiration of all four drug patents.
In order to calculate the cash flows with indirect approach, we firstly project the net incomes for the company. Given the probability of acquiring patents for each drug, we project the expected net income that each drug will contributes to the overall profits for the company as a whole. We assume the interest incomes and expenses remain the same and the ratio of account receivable and corresponding revenue and the ratio of account payable and total expenses remain the same as the average level of previous years.
Taking into account all four drug tests, we have the projection of PCYC cash flows though 2001 to 2013. (See Exhibit 3)
* Discount rate and firm value
To estimate the discount rate for the cash flows, we apply the CAPM model
Rate of return = rf+βu*(rm-rf)
We assume the risk free rate equals to 6.55%, the 10-year yield for the government bond (Appendix II) and the market return equals to 14%, the average total annum returns for the large companies in the U.S securities markets.
We first estimate the βu of Pharmacyclics before the approval of the drugs. Before 2002, the βe for the company is given as 0.97, since the interest bearing debt equal to zero, the βu of the company is computed as
Hence the discount rate equals
However, since the...