Question

1. Project Analysis and Inflation

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 $8.35 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 $4.10 per package in real terms for the headache-only brand. Production costs are expected to be $4.65 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 3%.

Either product requires further investment. The headache-only pill could be produced using equipment costing $23 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% and believes that the appropriate real discount rate is 7%. Which pain relieve should the firm produce?

Answer 1

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