Question

Carlisle Enterprises, a specialty pharmaceutical manufacturer, has been losing market share for three years since several key patents have expired. The free cash flow to the firm in 2002 was $10 million. This figure is expected to decline rapidly as more competitive generic drugs enter the market. Projected cash flows for the next five years are $8.5 million, $7.0 million, $5 million, $2.0 million, and $.5 million. Cash flow after the fifth year is expected to be negligible. The firm’s board has decided to sell the firm to a larger pharmaceutical company interested in using Carlisle’s product offering to fill gaps in its own product offering until it can develop similar drugs. Carlisle’s cost of capital is 15%. What purchase price must Carlisle obtain to earn its cost of capital?

Answer 1

To find the purchase price that Carlisle must obtain to earn its cost of capital, we are required to find out the present value of projected cash flows for next 5 years. Since, the cost of capital is 15%, we can use 15% as the discounting rate.

The formula to calculate present value is:

where, r = discounting rate

and, t = number of years

Following table shows the present values of future cash inflows for next 5 years.

From the table above, we have found out the total PV of future cash inflows, i.e., $17.36 million. This is the purchase price that Carlisle must obtain to earn 15% cost of capital.