Hot Tissue Corp., a young, biotechnology firm, is considering an initial public offering of common stock. The company has no debt, and it expects total revenue next year of $40 million. Revenues are expected to grow at an annual rate of 4% indefinitely thereafter. Cash operating expenses are expected to come to 50% of total revenues each year. Annual research and development expenditures are expected to be 10% of annual revenue, annual depreciation is expected to be 10% of annual revenue, and annual capital expenditures are expected to be 5% of annual revenue. The company’s tax rate is 35%. Although Hot Tissue currently has no publicly traded stock, the average beta for the stocks of comparable biotech firms is 1.25. The risk-free rate of return is 4% and the risk premium (market return minus risk-free rate) on the market portfolio is 8%.
a) What do you estimate the total discounted cash flow value of Hot Tissue to be?
b) Hot Tissue needs to invest $46.06 million now to realize the projected cash flows described in (a) above. Underwriting fees will total 6% of the issue, so the company will need to sell enough stock to raise a net total of $46.06 million, after underwriting fees. If investors valued the company the same way you did in part (a), what ownership share would the company have to sell in the initial public offering to raise a net $46.06 million?
c) Suppose in reality that Hot Tissue will have to sell a 65% share of the company’s equity to the public in order to raise the needed $46.06 million. In that event, what will be the net present value for investors who participate in the initial public offering?