Business – Cheap Research Essays

Chapter 6: Discussion Question: #4 p. 223
4.
Why is it usually easier to forecast sales for seasoned firms in contrast with early-stage ventures?
Chapter 6: Pharma BioTech Mini Case: pp. 229 – 230 Part A only
MINI CASE: Pharma Biotech Corporation

The Pharma Biotech Corporation spent several years working on developing a DHA product that can be used to provide a

fatty-acid supplement to a variety of food products. DHA stands for docosahexaenoic acid, an omega-3 fatty acid found

naturally in coldwater fish. The benefits of fatty fish oil have been cited in studies of the brain, the eyes, and the

immune system. Unfortunately, it is difficult to consume enough fish to get the benefits of DHA, and most individuals

might be concerned about the taste consequences associated with adding fatty fish oil to eggs, ice cream, or chocolate

candy. To counter these constraints, Pharma Biotech and several competitors have been able to grow algae and other plants

that are rich in DHA. The resulting chemical compounds then are used to enhance a variety of food products.

Pharma Biotech’s initial DHA product was designed as an additive to dairy products and yogurt. For example, the venture’s

DHA product was added to cottage cheese and fruit-flavored yogurts to enhance the health benefits of those products.

After the long product development period, Pharma Biotech began operations in 2009. Income statement and balance sheet

results for 2010, the first full year of operations, have been prepared.

Pharma Biotech, however, is concerned about forecasting its financial statements for next year because it is uncertain

about the amount of additional financing for assets that will be needed as Pharma Biotech Corporation the venture ramps

up sales. Pharma Biotech expects to introduce a DHA product that can be added to chocolate candies. Not only will

consumers get the satisfaction of the taste of the chocolate candies, but they will also benefit from the DHA

enhancement. Because this is anticipated to be a blockbuster new product, sales are anticipated to increase 50 percent

next year (2011), even though the new product will come online in midyear. An additional 80 percent increase in sales is

expected the following year (2012).
PHARMA BIOTECH CORPORATION
INCOME STATEMENT FOR DECEMBER 31, 2010 (THOUSANDS OF DOLLARS)
Sales 15,000
Operating expenses −13,000
EBIT 2,000
Interest −400
EBT 1,600
Taxes (40% rate) −640
Net income 960
Cash dividends (40% payout) −384
Added retained earnings 576
PHARMA BIOTECH CORPORATION
BALANCE SHEET AS OF DECEMBER 31, 2010 (THOUSANDS OF DOLLARS)
Cash and marketable securities $ 1,000 Accounts payable $ 1,600
Accounts receivable 2,000 Bank loan 1,800
Inventories 2,200 Accrued liabilities 1,200
Total current assets 5,200 Total current liabilities 4,600
Long-term debt 2,200
Common stock 2,400
Fixed assets, net 6,800 Retained earnings 2,800
Total assets $12,000 Total liabilities and equity $12,000

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cost of equity capital were based on a risk-free rate of 7 percent, a market risk premium of 8 percent, and a systematic

risk measure or beta of 2.0.
12.
[CAPM Estimate of Cost of Equity Capital] Voice River, Inc., has successfully moved through its early life cycle stages

and now is well into its rapid-growth stage. However, by traditional standards this provider of media-on-demand services

is still considered to be a relatively small venture. The interest rate on long-term U.S. government securities is

currently 7 percent. Voice River’s management has observed that, over the long run, the average annual rate of return on

small-firm stocks has been 17.3 percent, while the annual returns on long-term U.S. government securities has averaged

5.7 percent. Management views Voice River as being an average small-company venture at its current life cycle stage.
Chapter 7: Castillo Mini Case: pp. 264 – 265

MINI CASE: Castillo Products Company
The Castillo Products Company was started in 2008. The company manufactures components for personal digital assistant

(PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable

2010. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital because they are

expecting to secure additional external financing to support planned growth.
Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining

long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent, and a

long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A

default-risk premium on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a

liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on

large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect

that equity investors in their venture will require an additional investment risk premium estimated at two times the

market risk premium on large-firm common stocks.
Following are income statements and balance sheets for the Castillo Products Company for 2009 and 2010.
CASTILLO PRODUCTS COMPANY
INCOME STATEMENT 2009 2010
Net sales $ 900,000 $1,500,000
Cost of goods sold 540,000 900,000
Gross profit 360,000 600,000
Marketing 90,000 150,000
General and administrative 250,000 250,000
Depreciation 40,000 40,000
EBIT −20,000 160,000
Interest 45,000 60,000
Earnings before taxes −65,000 100,000
Income taxes 0 25,000
Net income (loss) $ −65,000 $ 75,000
BALANCE SHEET 2009 2010
Cash $ 50,000 $ 20,000
Accounts receivable 200,000 280,000
Inventories 400,000 500,000
Total current assets 650,000 800,000
Gross fixed assets 450,000 540,000
Accumulated depreciation −100,000 −140,000
Net fixed assets 350,000 400,000
Total assets $1,000,000 $1,200,000
Accounts payable $ 130,000 $ 160,000
Accruals 50,000 70,000
Bank loan 90,000 100,000
Total current liabilities 270,000 330,000
Long-term debt 300,000 400,000
Common stock ($0.05 par value) 150,000 150,000
Additional paid-in-capital 200,000 200,000
Retained earnings 80,000 120,000
Total liabilities and equity $1,000,000 $1,200,000
264
265
A. Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and

the return on equity for both 2009 and 2010 for the Castillo Products Corporation. Describe what happened in terms of

financial performance between the two years.
B. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the

Castillo Products Corporation.
C. Although, Castillo Products paid a low effective tax rate in 2010, a 30 percent income tax

rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans,

long-term debt, and the venture’s common equity.
D. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation

using the book values of interest-bearing debt and stockholders’ equity capital at the end of 2010.
E. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000

at the end of 2010. The market values of interest-bearing debt are judged to be the same as the recorded book values at

the end of 2010. Estimate the market value-based weighted average cost of capital for Castillo Products.
F. Would you recommend to Cindy and Rob that they use the book value–based WACC estimate or the

market value–based WACC estimate for planning purposes? Why?
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