Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilled with the resp
ID: 2783154 • Letter: D
Question
Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilled with the response he 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 is seriously considering two offers. Dr. Wolf’s required rate of return is 8%.
Offer #1: Hampton Drug Co. is offering $1,000,000 now plus $200,000 from end of year
6 through end of year 15. Also, if the product reaches 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 of cumulative sales reaching
$100 million.
Offer #2: Zbay Pharmaceutical is offering to pay Dr. Wolf a 35% royalty at the end of the next
four years. The royalty is based on Zbay's gross profit margin on expected sales.
Sales in year one are projected to be $2,000,000.
Sales are expected to grow each year by 40%.
Zbay’s gross profit margin is 65%.
Present Value of Offer #2
Determine the present value of Offer #1.
Present Value of Offer #2
Hampton Drug Co. is offering $1,000,000 now plus $200,000 from end of year 6 through end of year 15. Also if the product reaches 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 of cumulative sales reaching $100 million. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 Bonus if cumulative sales reach $100 million by end of year 15 $3,000,000 Payments by year Probability of cumulative sales reaching $100 million by end of year 15 70%Determine the present value of Offer #1.
In this offer, Zbay Pharmaceutical is offering to pay Dr. Wolf a 35% royalty at the end of the next four years. The royalty is based on Zbay's gross profit margin on expected sales. Sales in year one are projected to be Sales are expected to grow each year by Zbay's gross profit margin is Dr. Wolf's royalty as percent of gross profit Year Projected Sales Zbay Gross Profit Dr. Wolf's Payment 1 2 3 4 Determine the present value of Offer #2.Explanation / Answer
In this question we will calculate the present value of both the offers
Present value of offer will be sum of present value of all cash flows to Dr. Wolf
Present value = cash flow / (1+r)n, where r is required rate of return and n is number of years
r is 8%
For offer 1, Initial payment is $1,000,000
After that payment will start at end of year 6 to year 15 of $200,000
If cummulative sales exceed $100 million then there would be additional payment of $3,000,000 at end of year 15
Probaility of exceeding sales of $100 million is 70%
Present value of offer if sales exceed $100 million = 1,000,000 + 200,000/(1.08)6 + 200,000/(1.08)7 + .................................... + 200,000/(1.08)14 + 3,200,000/(1.08)15
Present value of offer if sales exceed $100 million = $2,859,078.85
Present value of offer if sales do not exceed $100 million = 1,000,000 + 200,000/(1.08)6 + 200,000/(1.08)7 + .................................... + 200,000/(1.08)14 + 200,000/(1.08)15
Present value of offer if sales do not exceed $100 million = 1,913,353.73
Present value of offer 1 = (0.7 * present value of offer if sales exceed $100 million) + (0.3 * present value of offer if sales do not exceed $100 million) = (0.7*2,859,078.85) + (0.3*1,913353.73) = 2,575,361.31
So present value of offer 1 = $2,575,361.31
For offer 2, Dr. Wolf will get 35% royalty for four years on gross profit
Gross Profit margin = 65%
Sales in year 1 = $2,000,000
Gross profit in year 1 = 2,000,000*0.65 = 1,300,000
Royalty = 35% of gross profit = 0.35*1300000 = $455,000
Sales will grow at 40%
Sales in year 2 = $2,000,000*1.4 = 2,800,000
Gross profit in year 2 = 2,800,000*0.65 = 1,820,000
Royalty = 35% of gross profit = 0.35*1820000 = $637,000
Sales in year 3 = $2,800,000*1.4 = 3,920,000
Gross profit in year 3 = 3,920,000*0.65 = 2,548,000
Royalty = 35% of gross profit = 0.35*2548000 = $891,800
Sales in year 4 = $3,920,000*1.4 = 5,488,000
Gross profit in year 4 = 5,488,000*0.65 = 3,567,200
Royalty = 35% of gross profit = 0.35*3567200 = $1,248,520
Present value of offer 2 = 455,000/(1.08)1 + 637,000/(1.08)2 + 891,800/(1.08)3 + 1,248,520/(1.08)4
Present value of offer 2 = $2,593,060.19
Out of both offers Dr. wolf should select offer 2 as its value is higher.
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