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In 2005, Arcadian Microarray technologies, Inc. were in talks with Sierra Capital Partners to sell a 60% equity interest for $40 million to fund the growth of the company. Sierra Capital is a private equity investment company with $2 billion under management and a portfolio of 64 venture capital investments and leverage buyouts focusing strictly on the life sciences sector. Arcadian Microarray is a biotechnology firm founded in 2003 and located in Arcadia, California. The business was made up of 2 segments, DNA microarrays and human therapeutics. Due to the highly risky and complicated nature of this industry, managing director of Sierra Capital Rodney Chu, was hesitant on the cash flow projections put forth by Arcadian. The final steps in Chu’s analysis were to estimate a terminal value for Arcadian and decide whether $40 million is an appropriate amount to invest in Arcadian. The case shows the current forecast assumptions for both Arcadian Microarray Technologies and Sierra Capital Partners to be very optimistic, but while undertaking quite some risk. Speculations tell us that DNA microarray technology will produce excellent returns, while experiencing high revenues.
This is where the problem at hand lies; will the value of the investment be sufficient enough to go through with the opportunity? The value can be determined through estimating its terminal value. Determining the terminal value of the investment will allow us to see the accumulated lump sum of cash flows at the end of a period and will tell us the present value of all cash flows beyond the prospected forecast. While estimating the terminal value, we thought the best option was to calculate the constant growth rate under that assumption of a WACC = 20%. With Arcadian’s management believing they can grow at 7% to infinity, it was difficult to determine which growth rate to look at in this situation. The options consisted of: the real growth rate in the economy (3%), the real growth rate in the Pharmaceutical Industry (5%), or the USA population growth rate (1%). In this situation, however, it was determined that we should be looking for a growth rate that incorporates inflation, the nominal rate. As shown in the text in Exhibit 6, using a 5% annual growth rate to infinity would only yield a total PV of $35 million. Selling a 60% equity interest to Sierra Capital Partners for $40 million would barely cover the cash insufficiency Sierra projected for next year (2005). This tells us that there is a need for further, more extensive financing for the years to follow (2006+).
We also calculated the terminal value estimates of Arcadian using a P/E multiples. The expected P/E multiples were provided (15-20) that result from the investment from Sierra Capital, we calculated the PV of the terminal values by using a WACC of 20%. In calculating the terminal value, our team used the last year in the forecast with a 5% nominal rate and discounted it back to present day along with all the other forecasted FCFs. Using P/E multiples, we estimated the terminal value by multiplying the net income for Arcadian in 2014, by 15 and 20 (Exhibit 1). Next, we calculated the total present value with the terminal value plus the negative PV free cash flow. Finally, the equity amount proposed to sell was calculated by 60% of total present value.
The sensitivity analysis run for us indicates that regardless of the growth rate we are expecting a significantly positive net present value. With a growth rate at only 2% we expect our present value to be over $33 and that’s the most conservative estimate. As our growth rate projections increase, so do the projections for net present value. Our most aggressive estimates have the growth rate compounding at 7% per year; in that scenario our net present value will more than double to $68. The most important thing isn’t so much the numbers associating with the growth rates but the margin of safety we have given our estimations. Projects without a margin of safety are vulnerable to a lot of outside factors, meaning if the growth rate falls short of expectation then the project won’t be profitable. Given our most conservative estimates, we don’t think there should be an issue with the growth rates.