Question

Please answer the followings for the pharmaceutical company according to the information below.
Department/ Beta /Market Value
R&D/ 2.3 /$200 million
Clinical Research/ 1.8/ $250 million
Operations/ 1.3/ $350 million
a. What is the beta of the equity for the firm?
b. If the risk free rate is 7% and the spread between the return on all stocks (market risk premium) is 7.5%, estimate the cost of equity for the R&D department?
c. What is the cost of equity for the entire firm?
d. Free cash flow to equity investors in the current year (FCFE) for the entire firm is $10.4 million and for the R&D department, it is $6.1 million. If the total firm and the R&D department are expected to grow at the same 9% rate into the foreseeable future, estimate the market value of the firm and of the R&D department.

Answer 1

A) Total market value of firm= sum of market value of different Department

= R& D + Clinical research + operations

= 200 + 250 + 350

= 800

Weight of R&D = 200 / 800 = 0.25

Weight of Clinical research = 250 / 800 = 0.3125

Weight of operations= 350 / 800 = 0.4375

Beta of equity for the firm = weight of R& D × beta of R&D + weight of clinical research × beta of clinical research + weight of operations × beta of operations

= 0.25 × 2.3 + 0.3125 × 1.8 + 0.4375 × 1.3

= 0.575 + 0.5625 + 0.56875

= 1.71

B) Cost of equity of R&D = Risk free rate + beta × market risk premium

= 7% + 2.3 × 7.5%

= 7% + 17.25%

= 24.25%

C) Cost of equity of firm = Risk free rate + beta × market risk premium

= 7% + 1.71 × 7.5%

= 7% + 12.825%

= 19.825%

D) Market value of R&D = FCFE (1+growth rate)/Cost of equity - growth rate

= 6.1 (1+0.09) / 0.2425 - 0.09

= 6.1 (1.09) / 0.1525

= 6.649 / 0.1525

= $43.6 million

Market value of entire firm= FCFE (1+growth rate) / cost of equity - growth rate

= 10.4 (1+0.09) / 0.19825 - 0.09

= 10.4 (1.09) / 0.10825

= 11.336 / 0.10825

= $104.72 million