The text indicates that small cap growth stocks have performed better over time

Question

The text indicates that small cap growth stocks have performed better over time in terms of total return. However this higher return is related to higher risk because during a market’s high growth phase many firms get shaken out of the market. Once the market matures the situation changes. Please explain the following relationships between a firm and its market stages of growth, the kind of financing it should be seeking, the providers of such external finance at each stage of a market’s development, the appropriate mix of debt to equity and how this can vary by industry.

Merck wants to develop a promising new NCE [New Chemical Entity] costing $800 million to $1 billion to bring through clinical trials to market. How would it expect to finance this project? What would the impact be on its D/E?

Explanation / Answer

I would recommend to finance the new project with 70% equity and 30% debt. Equity will distribute the ownership right among many shareholders but as this project is risky, it will not have to pay a certain dividend to common stockholders. On debt it will have to pay a fixed interest every year. So higher debt is not recommended at this time. Later, once the firm starts making good amount of profit, it can issue debt and buy back the common stocks to improve ROE of the firm.

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