In: Finance
Illinois Bio Technologies
Illinois Bio Technologies (IBTECH) was founded in Rosemont, Illinois, in 1992 by Kelly O'Brien, David Roberts, and Barbara Smalley. O'Brien and Roberts, both MDs, were on the research faculty at the Chicago Medical School at the time; O'Brien specialized in biochemistry and molecular biology, and Roberts specialized in immunology and medical microbiology. Smalley, who has a PhD, served a department chair of the Microbiology Department at the same school.
The company started as a research and development firm, which performed its own basic research, obtained patents on promising technologies, and then either sold or licensed the technologies to other firms which marketed the products. In recent years, however, the firm has also contracted to perform research and testing for larger genetic engineering and biotechnology firm, and for the U.S. government. Since its inception, the company has enjoyed enormous success - even its founders were surprised at the scientific breakthrough made and the demand for its services. One event that contributed significantly to the firm's rapid growth had been the AIDS research. Both the U.S. government and private foundations have spent billions of dollars in AIDS research, and IBTECH had the right combination of skills to garner significant grant funds, as well as perform as a subcontractor to other firm receiving AIDS research grant.
The founders were relatively wealthy individuals when they started the company, and they had enough confidence in the business to commit most of their own funds to the new venture. Still, the capital requirement brought on by extremely rapid growth soon exhausted their personal funds, so they were forced to raise capital from outside sources. First, in 2001, the firm borrowed heavily, and then in 2003, when it used up its conventional debt capacity, it issued $15 million of preferred stock. Finally, in 2006, the firm had an initial public offering (lPO) which raised $50 million of common equity. Currently, the stock trades in the over-the-counter market, and it has been selling at about $25 per share.
IBTECH is widely recognized as the leader in an emerging growth industry, and it won an award in 2008 for being one of the 100 best-managed small companies in the United States. The company is organized into two divisions: (1) the Clinical Research Division and (2) the Genetic Engineering Division. Although the two divisions are housed in the same buildings, the equipment they use and their personnel are quite different. Indeed, there are few synergies between the two divisions. The most important synergies lay in the general overhead and marketing areas. Personnel, payroll, and similar functions are all done at the corporate level, while technical operations at the divisions are completely separate.
The Clinical Research Division conduct most of the firm' AIDS research. Since most of the grant and contracts associated with AIDS research are long-term in nature, and since billion of new dollars will likely be spent in this area, the business risk of this division is low. Conversely, the Genetic Engineering Division works mostly on in-house research and short-term contracts where the funding, duration, and payoff are very uncertain. A line of research may look good initially, but it is not unusual to hit some snag, which preclude further exploration. Because of the uncertainties inherent in genetic research, the Genetic Engineering Division is judged to have high business risk.
The founders are still active in the business, but they no longer work 70-hour week. Increasingly, they are enjoying the fruits of their past labor, and they have let professional managers take over day-to-day operations. They are all on the board of director, though, and David Roberts is chairman.
Although the firm's growth has been phenomenal, it has been more random than planned. The founders would simply decide on new avenue of research, and then count on the skills of the research teams-and good luck-to produce commercial successes. Formal decision structures were almost nonexistent, but the company's head start and its bright, energetic founder easily overcame any deficiencies in its managerial decision processes. Recently, however, competition has become stiffer, and such large biotechnology firms such as Genentech, Amgen, and even Bristol-Myers Squibb have begun to recognize the opportunities in IBTECH's research line. Because of this increasing competition, IBTECH's founders and board of directors have concluded that the firm must apply state-of-the-art technique in its managerial processes as well as in its technological processes. As a first step, the board directed the financial vice president, Gary Hayes, to develop an estimate for the firm's cost of capital and to use this number in capital budgeting decisions. Hayes, in turn, directed IBTECH's treasurer, Julie Owens, to have a cost of capital estimate on his desk in one week. Owens has an accounting background, and her primary task since taking over as treasurer has been to deal with the banks. Thus, she is somewhat apprehensive about this new assignment especially since one of the board members is her former Kean University finance professor.
Table 1
Illinois Bio Technologies, Inc.
Balance Sheet for the Year Ended December 31, 2019
(In Millions of Dollars)
Cash and marketable securities |
$ |
7.6 |
Account payable |
$ |
5.7 |
Accounts receivable |
39.6 |
Accrual |
7.5 |
||
Inventory |
9.1 |
Notes payable |
1.9 |
||
Current assets |
$ 56.3 |
Current Liabilities |
$ 15.1 |
||
Long-term debt |
61.2 |
||||
Net fixed assets |
114.5 |
Preferred stock |
15.0 |
||
Common stock |
79.5 |
||||
Total assets |
170.8 |
Total claims |
170.8 |
To begin, Owen reviewed IBTECH's 2019 balance sheet, which is shown in Table 1. Next, she assembled the following data:
Year |
Dividend |
2015 |
0.72 |
2016 |
0.75 |
2017 |
0.85 |
2018 |
1.00 |
2019 |
1.09 |
Now assume that you were recently hired as Julie Owen’s assistant, and she has given you the task of helping her develop the firm's cost of capital. You will also have to meet with Gary Hayes and, possibly, with the president and the full board of directors (including the Kean University Professor) to answer any question they might have. With this in mind, Owens wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answer, so be sure you understand the logic behind any formula or calculation you use. In particular, be aware of potential conceptual or empirical problems that might exist.
a.Reinvested earnings are earnings generated internally, retained for purpose of re-investment , into the business--without distribution to the owners/ shareholders. |
So, it is their money and it has an opportunity cost of return that could have been earned by them ,if invested in some other income-generating proposition.Using it, is like borrowing form them. |
So,its cost is the return expected by the shareholders , on their equity funds. |
b. Cost of Reinvested earnings (as per CAPM )=RFR+(beta*Market risk premium) |
ie.8%+(1.2*(8%+6%))= |
24.8% |
c. T-bonds' returns are generally higher than T-Bill's returns, so they are generally preferred to set a higher bench-mark return. |
T-Bill rates can be used as risk-free rate , as they are for a shorter duration of 1 year or less--so fluctuations are less.Rates will be reliable --but can be used only for shorter-duration projects. |
d. An estimate of risk premium adopted by companies operating in similar trade, is obtained by studying the past /historical market performance--adapting it to suit one's peculiarities. Normally, for past market performances, companies use S&P 500 or some such rtaing agencies ,as benchmark. So, it is an average based on past performances of similar companies in the trade. |
Calculating risk premium, in-house , involves deciding on the risk free rate & the required rate of return. The difference between the two , is market risk premium--ie. The premium the investor wants to earn, over& above the risk free rate, for undertaking the said risky project---whose return's volatility (beta) is as estimated , in the industry. |
Formula for market risk premium=Expected /Required rate of return-Risk-free rate |
e.Cost of Reinvested earnings (as per CAPM )=RFR+(beta*Market risk premium) |
ie.8%+(1.2*(8%+6%))= |
24.8% |