Richard Grass is the healthcare analyst for Furrnon Investments and is reviewing the investment merits of the developing hospice industry. The hospice industry has a short history in the public market, as several companies have recently completed their initial public offering. Hospice services are provided to patients diagnosed with terminal illness as an alternative to aggressive medical management. The use of hospice services at skilled nursing facilities and assisted-living facilities is forecasted to continue its recent growth. Medicare is the primary payer for hospice services, accounting for 85% of the approximately $7 billion in industry's revenues. Hospice providers offer symptom and pain management to patients diagnosed with a terminal illness by their physician.The program was added to the Medicare benefit package in the early 1980s. Growth in the sector has only recently. accelerated due to the emergence of a number of for-profit companies. The caregiver provides a plan for each admitted patient and care is given in any number of healthcare environments, including the patient's home.Grass's analysis of the hospice industry has uncovered several facts that are outlined below:• The industry's revenue annual growth rate has increased from 14% in the late 1990s to 25% in 2008.• The average length of stay at facilities for hospice patients is increasing.• Labor costs account for 75% of total expenses, drugs 15% of total expenses, and medical supplies 10%.• More than 80% of hospice patients are above 65 years old and 30% are above 85 years old.• Based on the U.S. Census Bureau's statistics, over the next six years (2009-2015), the number of people in the 65 and older age group will increase annually by 1.4%.• The Medicare hospice benefit is still underutilized by the terminally ill population, according to MedPac (an independent advisory committee for the U.S. Congress on healthcare issues).• Only 30% of Medicare beneficiaries enroll in the hospice benefit before they die.• In recent years, the U.S. government has approved rate increases for the sector compared to flat or declining rate trends for other healthcare services.• The Medicare hospice program has a beneficiary cap which cannot exceed approximately$18,000 annually per person.• The top six for-profit providers account for about half of the segment's sales.• The overall hospice provider market is roughly divided into 55% non-profit, 10% U.S. government, and 35% for-profit.Grass's analysis has narrowed his search to Hope Company. Hope controls about 7% of the total hospice service market or 20% of the for-profit market. The company has the only regulator approved for-profit certificate for the state of Florida, one of the most attractive markets in the United States. In addition to a strong market share in Florida, Hope has a strong presence in urban markets like Dallas and San Francisco. Hope has a more diversified revenue base than other publicly traded for-profit providers.Grass is forecasting Hope Company's revenues and profits for the next year. Which of the following statements is least likely a risk Grass should consider in developing his forecast? Furmon Investment's economist is forecasting a:
Answer(s): B
Although an economic recession will have an impact on many companies, it is unlikely that Hope Company would be seriously impacted. The remaining answers would have a greater impact than a recession on Hopes revenues and profits. (Study Session 11, LOS 38.c,d)
Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for BioTLab for the most recent 12 months is provided below:• Net working capita! excluding cash increased from $7,460,000 to $9,985,000;• Book value increased from $81,250,000 to $101,250,000.• BioTLab currently has no debt.• Research facilities and production equipment were purchased for $8,450,000.• BioTLab held non-operating assets in the amount of $875,000.• Net income for the 12 months was $20,000,000.• BioTLab has a marginal tax rate of 40%.• Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.Johnson prefers to use free cash flow analysis to value investments. Which of the statements below is least accurate in describing the advantages of free cash flow valuation models?
An analyst must review the cash flows from a company's operating, investing and financing activities to generate a useful free cash flow, while dividends are simply set by the Board of Directors. Analysts use free cash flow whenever an investor takes a control perspective, such as in the event of an acquisition. The P/E model is considered weak because accounting issues can impact earnings. Companies that do not generate free cash flow in the long run are in financial trouble. (Study Session 12, LOS41.b,n)
Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for BioTLab for the most recent 12 months is provided below:• Net working capita! excluding cash increased from $7,460,000 to $9,985,000;• Book value increased from $81,250,000 to $101,250,000.• BioTLab currently has no debt.• Research facilities and production equipment were purchased for $8,450,000.• BioTLab held non-operating assets in the amount of $875,000.• Net income for the 12 months was $20,000,000.• BioTLab has a marginal tax rate of 40%.• Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.Using a two-stage, free cash flow to the firm model, determine which of the following is closest to the value of BioTLab.
Answer(s): C
Free cash flow to the firm (FCFF) can be calculated in many ways but in this question, you are given enough information to calculate the measure in the following way:FCFF = net income + non-cash charges + interest (1 - t) - fixed capital investment -working capital investmentFCF0 = 20,000,000 + 1,250,000 + 0 - 8,450,000 - (9,985,000 - 7,460,000) = 10,275,000The next step is to forecast the future FCFFs and the terminal value:terminal value = 16,054,688(1.12) / (0.15 -0.J2) = 599,375,000Next, calculate the present value of the FCFFs and the terminal value:terminal value = 16,054,688(1.12) / (0.15 -0.J2) = 599,375,000Next, calculate the present value of the FCFFs and the terminal value: If a firm has non-operating assets (e.g., land held for investment) on its balance sheet, the value of these assets must be added to the value of the operating assets (determined using the present value of the FCFFs and terminal value) to find the total firm value.Total firm value = value of operating assets + value of non-operating assets Total firm value = 476,521,739 + 875,000 = 477,396,739(Study Session 12. LOS 41.k)
Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for BioTLab for the most recent 12 months is provided below:• Net working capita! excluding cash increased from $7,460,000 to $9,985,000;• Book value increased from $81,250,000 to $101,250,000.• BioTLab currently has no debt.• Research facilities and production equipment were purchased for $8,450,000.• BioTLab held non-operating assets in the amount of $875,000.• Net income for the 12 months was $20,000,000.• BioTLab has a marginal tax rate of 40%.• Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.If BioTLabs establishes a dividend and issues additional debt, the most likely effect on FCFF will be;
Answer(s): A
If BioTLab established a dividend rhere would no impact on either FCFF or FCFE. Changing the company capital structure by increasing debt will not impact FCFF, although it will initially increase FCFE by the amount of debt issued and then reduce FCFE thereafter by the after- tax interest expense. (Study Session 12, LOS 41.h)
Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. Financial information for BioTLab for the most recent 12 months is provided below:• Net working capita! excluding cash increased from $7,460,000 to $9,985,000;• Book value increased from $81,250,000 to $101,250,000.• BioTLab currently has no debt.• Research facilities and production equipment were purchased for $8,450,000.• BioTLab held non-operating assets in the amount of $875,000.• Net income for the 12 months was $20,000,000.• BioTLab has a marginal tax rate of 40%.• Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.Which model would be most appropriate in valuing the Groh Group?
The FCFF model is better than the FCFE model in valuing debt laden, cyclical companies and companies with a changing capital structure. Since Groh Group does not pay a dividend, the DDM model would be the least appropriate model to value the company. (Study Session 12, LOS 41.b,h)
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