After extensive medical and marketing research, Pill, Inc., believes it can pene

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 $8.50 per package in real terms. The headache-only medication is projected to sell 3 million packages a year, while the headache and arthritis remedy would sell 4.7 million packages a year. Cash costs of production in the first year are expected to be $4.25 per package in real terms for the headache-only brand. Production costs are expected to be S4.80 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 $27 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 51 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 8 percent. Calculate the NPV for the headache pain reliever only. Calculate the NPV for the headache and arthritis pain reliever.

Explanation / Answer

Medication of headache pain:

no of units= 3mn, Selling price=$8.5 per package; Cost price=$4.25 Inflation=2%
Initial Investment=$27mn

initial investment=-27mn
Cash inflow:
For year 1= (8.5-4.25)*3*10^6=$12.75mn
For year 2= (8.5-4.25)*3*10^6=$12.75mn
For year 3= (8.5-4.25)*3*10^6=$12.75mn
Taxes= 12.75*34%=$4.335 mn

Tax rebate because of depreciation= 27/3*0.34=$3.06mn. since this is nominal cash flow we have to discount it at nominal rate

Real cash flows:
Year 0=-27
Year 1=12.75-4.335=8.415mn
Year 2=12.75-4.335=8.415mn
Year 3=12.75-4.335=8.415mn

Nominal cash flow:
Year 0=0
Year 1 =3.06 mn,Year 2 =3.06 mn,Year3 =3.06 mn
Nominal interest rate=8+2=10%
NPV=-27+(8.415/1.08)+(8.415/1.08^2)+(8.415/1.08^3)+(3.06/1.1)+(3.06/1.1^2)+(3.06/1.1^3)
=$2,296,038

2)Broad pain reliever

No of units= 4.7mn, Selling price=$8.5 per package; Cost price=$4.8 Inflation=2%
Initial Investment=$30mn

initial investment=-27mn
Cash inflow:
For year 1= (8.5-4.8)*4.7*10^6=$17.39mn
For year 2= (8.5-4.8)*4.7*10^6=$17.39mn
For year 3= (8.5-4.8)*4.7*10^6=$17.39mn
Taxes= 17.39*34%=$5.9126 mn

Tax rebate because of depreciation= 30/3*0.34=$3.4mn. since this is nominal cash flow we have to discount it at nominal rate
Salvage 1mn taxed at 34%

Real cash flows:
Year 0=-30
Year 1=17.39-5.9126=11.4774mn
Year 2=17.39-5.9126=11.4774mn
Year 3=17.39-5.9126=11.4774+1-0.34=12.1374

Nominal cash flow:
Year 0=0
Year 1 =3.4 mn,Year 2 =3.4 mn,Year3 =3.4 mn
Nominal interest rate=8+2=10%
NPV=-30+(11.4774/1.08)+(11.4774/1.08^2)+(12.1374/1.08^3)+(3.4/1.1)+(3.4/1.1^2)+(3.4/1.1^3)
=$8,557,599

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