Question

After extensive medical and marketing research, Pill, Inc., believes it can penetrate the pain reliever market. It is considering two alternative products. The first is to produce a medication for headache pain. The second is a pill for headache and arthritis pain. Both products would be introduced at a price of $9.15 per package in real terms. The headache-only medication is projected to sell 2 million packages a year, while the headache and arthritis remedy would sell 3.5 million packages a year. Cash costs of production in the first year are expected to be $5.05 per package in real terms for the headache-only brand. Production costs are expected to be $5.60 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 2 percent.

Either product requires further investment. The headache-only pill could be produced using equipment costing $18 million. That equipment would last three years and have no resale value. The machinery required to produce the broader remedy would cost $30 million and last three years. The firm expects that equipment to have a $1 million resale value (in real terms) at the end of Year 3.

The company uses straight-line depreciation. The firm faces a corporate tax rate of 34 percent and believes that the appropriate real discount rate is 6 percent.

Calculate the NPV for the Headache-Only product

Calculate the NPV for the Headache and Arthritis Product

-Please show how you got the answer

Answer 1

HEADACHE ONLY MEDICATION:	0	1	2	3
Sales (2000000*9.15+inflation of 2%		18300000	18666000	19039320
Cash production costs (2000000*5.05+inflation of 2%)		10100000	10302000	10508040
Depreciation (18000000/3)		6000000	6000000	6000000
NOI		2200000	2364000	2531280
Tax at 34%		748000	803760	860635
NOPAT		1452000	1560240	1670645
Add: Depreciation		6000000	6000000	6000000
OCF		7452000	7560240	7670645
Capital spending	18000000
FCF	-18000000	7452000	7560240	7670645
PVIF at 8.12% [1.06*1.02-1=0.0812]	1	0.92490	0.85544	0.79119
PV at 8.12%	-18000000	6892342	6467307	6068953
NPV	1428602
HEADACHE AND ARTHRITIS MEDICATION:	0	1	2	3
Sales (3500000*9.15+inflation of 2%		32025000	32665500	33318810
Cash production costs (3500000*5.60+inflation of 2%)		19600000	19992000	20391840
Depreciation (30000000/3)		10000000	10000000	10000000
NOI		2425000	2673500	2926970
Tax at 34%		824500	908990	995170
NOPAT		1600500	1764510	1931800
Add: Depreciation		10000000	10000000	10000000
OCF		11600500	11764510	11931800
Capital spending	30000000			-700397
FCF	-30000000	11600500	11764510	12632197
PVIF at 8.12% [1.06*1.02-1=0.0812]	1	0.92490	0.85544	0.79119
PV at 8.12%	-30000000	10729282	10063795	9994494
NPV	787571
NOTE:
TERMINAL NON-OPERATING CASH FLOW OF HEADACHE AND ARTHRITIS PRODUCT:
Sale value in nominal dollar terms = 1000000*1.02^3 =	1061208
Tax at 34%	360811
After tax sale proceeds	700397