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 $8.50 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 4.7 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 $4.80 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 $1,100,000 resale value (in real terms) at the end of Year 3.

  

The firm uses straight-line depreciation and has a tax rate of 23 percent. The appropriate real discount rate is 8 percent.

  

a.Calculate the NPV for headache pain reliever only. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

b.Calculate the NPV for headache and arthritis pain reliever. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

Solution:

a)Calculation of NPV of headache pain reliever

i)Annual Depreciation=Cost of Equipment/life

=$27/3=$9 million

ii)Statement showing after tax cash inflows for each year

Year	1($ in million)	2($ in million)	3($ in million)
[email protected]	25.50	25.50	25.50
Less:[email protected]	12.75	12.75	12.75
Net Revenue	12.75	12.75	12.75
Add:Inflation @2%		0.255	0.5151
Total Revenue	12.75	13.005	13.2651
Less:Depreciation	9.00	9.00	9.00
EBT	3.75	4.005	4.2651
Less:tax @23%	0.8625	0.92115	0.9810
EAT	2.8875	3.08385	3.2841
Add:Depreciation	9	9	9
After tax cash inflows	11.8875	12.08385	12.2841

iii)Present value of cash inflows using discount rate of 8%

=11.8875/(1+.08)^1+12.08385/(1+.08)^2+12.2841/(1+.08)^3

=$31.1184128 million

iv)NPV=Present value of cash inflows-Initial Investment

=$31.1184128 million-$27 million

=$4.1184128million

Thus NPV for headache pain reliever is 4,118,412.78