Question

Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilled with the response he had received from drug companies for his latest discovery, a unique electronic stimulator that reduces the pain from arthritis. The process had yet to pass rigorous Federal Drug Administration (FDA) testing and was still in the early stages of development, but the interest was intense. He received the three offers described below this paragraph. (A 10 percent interest rate should be used throughout this analysis unless otherwise specified.) Offer 1 $1,000,000 now plus $200,000 a year from year 6 through 15. Also if the product did over $100 million in cumulative sales by the end of year 15, he would receive an additional $3,000,000. Dr. Wolf thought there was a 70 percent probability this would happen. Qffer // Thirty percent of the buyer's gross profit on the product for the next four years. The buyer in this case was Zbay Pharmaceutical. Zbay's gross profit margin was 60 percent. Sales in year one were projected to be $2 million and then expected to grow by 40 percent per year. Offer III A trust fund would be set up for the next 8 years. The trust fund called for semiannual payments for the next 8 years of $200,000 (a total of $400,000 per year). The payments would start immediately. Assume the annual interest rate on this annuity is 10 percent annually (5 percent semiannually). Determine the present value of the trust. Which offer would you advise Dr. Wolf to take? For part (a), you need to use (time-line and formulas only. For part (b) you need to use your calculator functions (PV, FV, PMT, I/Y, and N) to estimate the value of each offer. Compare the answers from parts (a) & (b); they must match!

Answer 1

Dr. Harold should choose the offer which has the best net present value (NPV). Hence, we shall calculate NPV for each offer separately.

Offer 1: -

Year	PVF @10%	Amount	PV
6	0.56	2,00,000	1,12,895
7	0.51	2,00,000	1,02,632
8	0.47	2,00,000	93,301
9	0.42	2,00,000	84,820
10	0.39	2,00,000	77,109
11	0.35	2,00,000	70,099
12	0.32	2,00,000	63,726
13	0.29	2,00,000	57,933
14	0.26	2,00,000	52,666
15	0.24	2,00,000	47,878
			7,63,059
Add:	To be received today		10,00,000
			17,63,059
Add: Additional amount on sales	70 % probability		5,04,000
	(30,00,000*70%*0.24)
Net Present Value			22,67,059

Offer 2 :-

Year	1	2	3	4	total NPV
Sales	20,00,000	28,00,000	39,20,000	54,88,000
Gross Profit @60%	12,00,000	16,80,000	23,52,000	32,92,800
Dr. share @30%	3,60,000	5,04,000	7,05,600	9,87,840
PVF @10%	0.91	0.83	0.75	0.68
Present Value	3,27,273	4,16,529	5,30,128	6,74,708	19,48,637

Offer 3: The payments in this case are starting at the beginning of the year. In this case, the formula for PV for annuity is:

P = PMT x ((1 - (1 / (1 + r) ^ n)) / r) x (1 + r), where

PMT = annuity, r=rate for period, n=periods

= 200000*((1-(1/ (1+0.05)^16))/0.05)*(1.05)

= $22,75,932

Hence, from the above three scenarios, Dr. Wolf should choose option 3 since it has the highest net present value.

Hope the above clarifies, please let me know in case of any clarifications.