Question

4.Genzyme is a local biotechnology firm that invests heavily in research and development.

(a) Currently, Genzyme re-invests all of its cashflows to help fund new R&D. Investors expect Genzyme to produce zero net cashflows for the next 5 years. In the 6th year, Genzyme is expected to have cashflows of $100 million, which is then expected to grow at a constant rate of 8% forever. If investors require a 13% rate of return, what is the current value of Genzyme? (Assume all cashflows occur at the end of the year.)

(b) Genzyme announces that it has just discovered a new drug, Heartgo, to treat heart disease. The firm has already spent $40 million developing Heartgo, and will have to spend an additional $10 million immediately to prepare the drug for sale. Heartgo is expected to generate cashflows of $30 million for 10 years, with the first cashflow received in one year. What is the new market value of Genzymeafter the announcement?

Answer 1

4a]

Terminal value at end of year 5 = cash flow in year 6 / (required return - constant growth rate)

Terminal value at end of year 5 = $100 million / (13% - 8%) = $2 billion

Current value = present value of terminal value (discounted at the required rate of return)

Current value = $2 billion / (1+ 13%)^5 = $1,085,519,872

4b]

The $40 million already spent is a sunk cost, and is therefore irrelevant. This is because this is an expense that is already incurred, and is not an expense that will be incurred only if the new drug is sold.

New market value = current value + NPV of new drug sale

current value is calculated above in question 4(a)

NPV of new drug sale = PV of cash inflows - additional immediate investment

NPV of new drug sale = ($30 million / 1.13) + ($30 million / 1.13²) + ($30 million / 1.13³)+...+($30 million / 1.13¹⁰) - $10 million

NPV of new drug sale = $152,787,304

New market value = $1,085,519,872 + $152,787,304 = $1,238,307,176