Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilled with the resp

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 in the following paragraph. (A 10 percent interest rate should be used throughout this analysis unless otherwise specified.)

The payments would start immediately. Since the payments are coming at the beginning of each period instead of the end, this is an annuity due. Assume the annual interest rate on this annuity is 10 percent annually (5 percent semiannually). Determine the present value of the trust fund's final value. Hint: See the section on Annuities Due.

REQUIRED:  Find the present value of each of the three offers and indicate which one has the highest present value.

OFFER I: $1,000,000 now plus $200,000 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.

OFFER 2: 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 3: A trust fund would be set up for the next eight years. At the end of that period, Dr. Wolf would receive the proceeds (and discount them back to the present at 10 percent). The trust fund called for semiannual payments for the next eight years of $200,000 (a total of $400,000 per year).

The main issue I am having is with the calculations for Offer 3. I have done it one way, my partner has done it another and we have come up with different answers.

Explanation / Answer

Answer

Medical Research Corporation

Offer 1

$ 1,000,000 now plus:

+$ 200,000 from year 6 through 15(deferred annuity)

Appendix D

PV(Annuity)= A x PV Annuity(10% , 10 years)

= $ 200,0000 x 6.145= $ 1229000(percent value at the begining of Year 6 i.e at the end of year 5)

Appendix B

PV= FV x PV (10%, 5 YEARS)

= $ 1229000 X 0.621

= $ 763209

+0.70 X $ 3000,000= $ 2100,000

APPENDIX B

PV = FV X PV (10 % , 15 YEARS)

= $ 2100,000 X 0.239 = $ 501900

TOTAL VALUE OF OFFER 1

$ 1000,000 PAYMENT TODAY

763209 PRESENT VALUE OF Deferred Annuity

501900 PRESENT VALUE OF $ 3 MILLION BONUS

______________

$ 2265109

___________

OFFER II

TOTAL VALUE OF OFFER II = $ 1947981

OFFER III

FUTURE VALUE OF AN ANNUITY DUE (APPENDIX C)

8 YEARS - SEMIANNUALLY

N= 16+1=17

i= 10% /2 = 5 %

FV (IFA) = 25.840-1 = 24.840 (APPENDIX C)

FV (A) = A X FV (IFA)

= $ 200000 X 24.840

= $ 4968000 VALUE OF TRUST FUND AFETR 8 YEARS

PRESENT VALUE OF TRUST FUND (APPENDIX B)

PV = A X PV (10% , 8 YEARS)

= $ 4968000 X 0.467

= $ 2320,056 TOTAL VALUE OF OFFER III

SUMMARY

VALUE OF OFFER I $ 2265109

VALUE OF OFFER II $ 1947981

VALUE OF OFFER III $ 2320056

SELECT OFFER III

YEAR SALES $ GROSS PROFIT(60% OF SALES) PAYMENT (30% OF GROSS PROFIT) 1 2000,000 1200,000 360,000 2 2800,000 1680,000 504000 3 3920000 2352000 705600 4 5488000 3292800 987600

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