ABC Pharma Inc. is a pharmaceutical company that traditionally has not used debt to finance its projects. Over the last 10 years, it has also reported high returns on its projects and growth, and made substantial research and development expenses over the time period. The health care business overall is growing much slower now, and the projects that the firm is considering have lower expected returns. a. How would you justify the firmís past policy of not using debt? b. Do you think the policy should be changed now? Why or why not
Answer: a. The past policy of not using debt can be justified by noting that returns on projects were high (increasing the need for flexibility) and that earnings in the future were likely to be volatile (because of the growth). b. Given that returns on projects are declining, I would argue for a greater use for debt.
Two firms are considering borrowing. One firm has excellent prospects in terms of future projects and is in an area in which cash flows are volatile and future needs are difficult to assess. The other firm has more stable cash flows and fewer project opportunities and predicts its future needs with more precision. Other things remaining equal, which of these two firms should borrow more?
The second firm should borrow more because 1. It has lower bankruptcy costs due to more predictable cash flows. 2. It does not have as much of a need for flexibility because its future needs are known
Under what conditions will the return on equity on a project be equal to the internal rate of return, estimated from cashflows to equity investors, on the same project?
This will occur only if: 1. Earnings are equal to cash flows to equity, i.e., there are no non-cash charges, working capital or cap ex. 2. Earnings are level over time.