Question

Welsh Meds Plc Mini Case

Welsh Meds Plc is a small but rapidly growing biotechnology company in Cardiff with annual revenues of £115 million. Last year’s net income was £6.38 million. Founded in 2002 by Carwyn Thomas and Geraint Jones with the support of a venture capitalist, the firm’s success has been remarkable. After a three year development phase, thecompany’s breakthrough was brought about by a drug called Enzyme Shield that was designed to treat immune system deficiencies (ISD). To fund the substantial increase in production capacity, which the owners decided should remain in-house, Carwyn and Geraint took Welsh Meds public, thereby taking advantage of the favorable stock market conditions of 2006. By issuing 2.8 million shares at £19, £53.2 million of equity were raised. Two years ago, Welsh Meds made its first annual dividend payment of £0.40 which increased by 15% last year. Ten months ago, the company received the Drug Administration Authority’s approval the mass market Enzyme Shield Light, a derivative of its first drug was specifically targets ISD in younger children. As a result, last quarter company earnings are up 37%, compared to the previous quarter. Carwyn and Geraint are very optimistic about Welsh Meds’ future and wonder if it is time to reward its shareholders with either a special one-time dividend of £2.50 or an increase of the annual dividend by £1.00. William Stewart, the company’s CFO, however, suggests using half of the accumulated cash of £12 million to initiate a buy back. In addition, Mr. Stewart would like to reduce the company’s debt by 4 million, thereby maintaining a cash reserve of only £2 million. Recovering from the global financial crisis when shares of Welsh Med fell by more than half, its current share price £17.38 is still, down 32% from its peak £25.55 of summer 2007. However, Carwyn and Geraint are very optimistic that the economic recovery will continue and that their company’s share price will reach new highs within the next 2–3 years.

QUESTIONS

1. Do you think it was prudent to initiate annual dividend payments only 3 years after the IPO?

2. If a special one-time dividend was paid, how would it likely affect Welsh Meds’ share price?

3. Would the share price reaction be different if the annual dividend was raised by £1.00 instead?

4. What is the current dividend payout ratio and how would it change if the annual dividend was raised by £1.00?

5. Based on the current share price of £17.63, determine the company’s implied cost of capital according to the dividend discount model (DDM).

6. What do you think about the owner’s optimistic view that the share price will reach new highs in 2–3 years? Is a share price of £25.55 or higher realistic under the current dividend growth rate assumption?

7. Is the commonly used DDM that assumes a constant and perpetual growth rate applicable to Welsh Meds? Explain.

8. How would the suggested debt reduction affect the company’s P/E ratio, return on assets, and return on equity?

9. How would the suggested share repurchase affect the company’s P/E ratio, return on assets, and return on equity?

10. Would you regard a £2 million cash reserve as sufficient for Welsh Meds? Explain.

Answer 1

1. Do you think it was prudent to initiate annual dividend payments only 3 years after the IPO?

Answer: Yes, it was a very effective measure to initiate annual dividend only after 3 years of IPO especially during a time of financial crisis which boosted the shareholder confidence, as it is a healthy sign if a company is passing back profits to its investors, not only will it encourage existing share holders to stay invested in your stock but also attract new retail investors who are looking for a good dividend yielding stock with promising returns

2. If a special one-time dividend was paid, how would it likely affect Welsh Meds’ share price?

Answer: It would adversely affect the share price as it will dry up the cash reserves which will be needed for the buy back, if we pay normal dividend of 1.40 pounds per share instead of special dividend of 2.5 pounds it will result in significant savings of about 2.9 million pounds for this year as path to recovery will be difficult and spending should be at minimal  

3. What is the current dividend payout ratio and how would it change if the annual dividend was raised by £1.00?

Based on the current share price of £17.63, determine the company’s implied cost of capital according to the dividend discount model (DDM).

What do you think about the owner’s optimistic view that the share price will reach new highs in 2–3 years? Is a share price of £25.55 or higher realistic under the current dividend growth rate assumption?

Answer: I think the owners have a realistic view as their product line is promising and revenues are strong only if they manage cash reserves efficiently the stock price will be trading higher in 2-3 years.

Is the commonly used DDM that assumes a constant and perpetual growth rate applicable to Welsh Meds? Explain.

Answer: Maybe not as the business is quite new and is going through the boom bust cycle for the first time it will be difficult to assess whether DDM is applicable here or not. As is with any business DDM is not completely accurate in valuing a business as the assumption that a business will declare constant growth in their dividends is highly unrealistic and debatable.

How would the suggested debt reduction affect the company’s P/E ratio, return on assets, and return on equity?

Answer: Debt reduction will not affect the P/E ratio but it will reduce interest cost in the subsequent years and the profit will higher. in the near term Balance sheet will be favourable as it will be less exposed to Debt and the Debt to equity ratio will be improved

Would you regard a £2 million cash reserve as sufficient for Welsh Meds? Explain.

Answer: 2m cash reserve is not sufficient for a company as large as Welsh and also it may need cash for contingencies hence they should focus on efficient cash management and sustained dividend payouts

How would the suggested share repurchase affect the company’s P/E ratio, return on assets, and return on equity?

Answer: Repurchase will boost investor confidence and also strengthen balance sheet by increasing ownership by the company and maybe they can aim at retiring some of the re-purchased shares to improve the position.