Question

Welsh Meds Plc is a small but rapidly growing biotechnology company in Cardiff with annual revenues of £115 million. Last year’s net income was £6.38 million. Founded in 2002 by Carwyn Thomas and Geraint Jones with the support of a venture capitalist, the firm’s success has been remarkable. After a three year development phase, the company’s breakthrough was brought about by a drug called Enzyme Shield that was designed to treat immune system deficiencies (ISD). To fund the substantial increase in production capacity, which the owners decided should remain in-house, Carwyn and Geraint took Welsh Meds public, thereby taking advantage of the favorable stock market conditions of 2006. By issuing 2.8 million shares at £19, £53.2 million of equity were raised. Two years ago, Welsh Meds made its first annual dividend payment of £0.40 which increased by 15% last year. Ten months ago, the company received the Drug Administration Authority’s approval the mass market Enzyme Shield Light, a derivative of its first drug was specifically targets ISD in younger children. As a result, last quarter company earnings are up 37%, compared to the previous quarter. Carwyn and Geraint are very optimistic about Welsh Meds’ future and wonder if it is time to reward its shareholders with either a special one-time dividend of £2.50 or an increase of the annual dividend by £1.00. William Stewart, the company’s CFO, however, suggests using half of the accumulated cash of £12 million to initiate a buy back. In addition, Mr. Stewart would like to reduce the company’s debt by 4 million, thereby maintaining a cash reserve of only £2 million. Recovering from the global financial crisis when shares of Welsh Med fell by more than half, its current share price £17.38 is still, down 32% from its peak £25.55 of summer 2007. However, Carwyn and Geraint are very optimistic that the economic recovery will continue and that their company’s share price will reach new highs within the next 2–3 years. QUESTIONS 1. Do you think it was prudent to initiate annual dividend payments only 3 years after the IPO?

1. What do you think about the owner’s optimistic view that the share price will reach new highs in 2–3 years? Is a share price of £25.55 or higher realistic under the current dividend growth rate assumption?

2. Is the commonly used DDM that assumes a constant and perpetual growth rate applicable to Welsh Meds? Explain

3. How would the suggested debt reduction affect the company’s P/E ratio, return on assets, and return on equity?

4. How would the suggested share repurchase affect the company’s P/E ratio, return on assets, and return on equity?

5. Would you regard a £2 million cash reserve as sufficient for Welsh Meds? Explain.

Answer 1

1. What do you think about the owner’s optimistic view that the share price will reach new highs in 2–3 years? Is a share price of £25.55 or higher realistic under the current dividend growth rate assumption?

Current share price = S₀ = 17.38; Share price after three years = S₃ = 25.55

Expected growth = (S₃ / S₀)^1/3 - 1 = (25.55 / 17.38)^1/3 - 1 = 13.71% which is around the 15% growth rate in dividend that we have assumed in earlier parts. Hence, the share price of 25.55 is realistic.

2. Is the commonly used DDM that assumes a constant and perpetual growth rate applicable to Welsh Meds? Explain

DDM is a model that assumes that dividends will grow at a constant and perpetual growth rate and hence it translates into the formula, P₀ = D₁ / (K_e - g). It therefore assumes that dividends in future will continue to grow at a rate of g till eternity.

Welsh Med is a rapidly growing Biotechnology firm:

• A technology firm's future is highly dependent upon success and failures of its research and development activities.
• The cash flows may not always be stable for such kind of firms
• Hence, dividend payments will also not be stable
• Hence, assuming a constant and perpetual growth rate in dividend for such kind of stock will in general be wrong.

Hence, we are better off by saying that DDM is not applicable to Welsh Med.

3. How would the suggested debt reduction affect the company’s P/E ratio, return on assets, and return on equity?

A debt reduction will improve the net income and hence the EPS as interest expenses will go down. Because of improvement in EPS, Price will also improve. Hence, P/E should in general approve but exact behavior can't be predicted. Return on assets and Return on equity both have net income in the denominator and hence will improve.

4. How would the suggested share repurchase affect the company’s P/E ratio, return on assets, and return on equity?

Net income will remain the same, however number of shares outstanding after the repurchase will decrease. Hence, EPS will increase. But then price will also increase. hence exact behavior of P/E is difficult to ascertain. If buyback takes place at current market price, P /E will remain unchanged.

Share repurchase will reduce the equity reported on the balance sheet. Hence, ROE will now have lower denominator and hence it will improve.

Surplus cash will move out from the asset side, so the total asset size will also reduce. Hence ROA will will now have lower denominator and hence it will improve.

5. Would you regard a £2 million cash reserve as sufficient for Welsh Meds? Explain.

Well, the debate on level of sufficient cash reserve continues. No quantum of cash level today can assure me sufficiency of cash for future. Given Welsh is a rapidly growing biotechnology company whose success is dependent upon future research and development activities that are usually capital intensive, a reserve of 2 mn appears to be short for Welsh med.