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 a medication for headache pain. The second is a pill for headache and arthritis pain. Both products would be introduced at a price of $8.25 per package in real terms. The headache-only medication is projected to sell 3 million packages a year, whereas the headache and arthritis remedy would sell 4.5 million packages a year. Cash costs of production in the first year are expected to be $4.15 per package in real terms for the headache-only brand. Production costs are expected to be $4.55 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 3 percent.

Either product requires further investment. The headache-only pill could be produced using equipment costing $22 million. That equipment would last three years and have no resale value. The machinery required to produce the broader remedy would cost $32 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.

Pill, Inc., uses straight-line depreciation. The firm faces a corporate tax rate of 34 percent and believes that the appropriate real discount rate is 7 percent. Which pain reliever should the firm produce?