Star Biotech Ltd. has been purchased by a venture capital company, JLM Inc. for $50 million. With JLM's help, Star has been able to negotiate a $30 million loan at 12% per year that immediately improved its liquidity position and allows Star to support the marketing of its innovative product line. Star projects its cash flow before depreciation, interest and taxes in the first two years will be: $5 million and $9.6 million, respectively, and after that will increase each year by 25% over the previous year. JLM Inc. wants to wait until end of the year in which the loan is paid off before selling Star. Ignoring income taxes and assuming all earnings go into paying off the debt, if JLM Inc. expects a 30% return on its capital employed, how much will JLM have to sell Star Biotech Ltd. for?

Question

Quizplus · Accepted Answer

First, we need to calculate the future cash flows of Star Biotech Ltd. over the holding period of JLM Inc.:
Year 1: $5 million
Year 2: $9.6 million
Year 3: $12.0 million (25% increase from Year 2)
Year 4: $15.0 million (25% increase from Year 3)
Year 5: $18.8 million (25% increase from Year 4)
Year 6 (when JLM Inc. plans to sell): $23.5 million (25% increase from Year 5)

We can calculate the present value of these cash flows using a discount rate of 30%:
PV = Year 1 + Year 2/(1+r)^2 + Year 3/(1+r)^3 + Year 4/(1+r)^4 + Year 5/(1+r)^5 + Year 6/(1+r)^6
PV = $5 million + $9.6 million/(1.3)^2 + $12.0 million/(1.3)^3 + $15.0 million/(1.3)^4 + $18.8 million/(1.3)^5 + $23.5 million/(1.3)^6
PV = $49.24 million

Adding the $30 million loan to this, we get a total enterprise value of $79.24 million. If JLM Inc. wants to achieve a 30% return on its capital employed, it must sell Star Biotech Ltd. for:
Sale price = $79.24 million x (1+30%) = $102.992 million

Therefore, the best choice is B.