Question

Dr. Scott DeMello of Medical Center Corporation (MCC) 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 below this paragraph. (A 10 percent interest rate should be used throughout this analysis unless otherwise specified.) Offer I: $1,000,000 now plus $220,000 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 $2,800,000. Dr. DeMello thought there was a 75 percent probability this would happen. Offer II: Thirty percent of the buyer's gross profit on the product for the next four years. The buyer in this case was Bayer Pharmaceutical. Bayer's profit margin was 65 percent. Sales in year one were projected to be $1,900,000 and then expected to grow by 45 percent per year. Offer III: A trust fund would be set up for the next 9 years. At the end of that period, Dr. DeMello would receive the proceeds (and discount them back to the present at 10 percent). The trust fund called for semiannual payments for the next 9 years of $200,000 (a total of $400,000 per year). 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). Required: Find the present value of each of the three offers and indicate which one you would recommend Dr. DeMello to choose.

          Dr. Scott DeMello of Medical Center Corporation (MCC) 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 below this paragraph. (A 10 percent interest rate should be used throughout this analysis unless otherwise specified.)

Offer I: $1,000,000 now plus $220,000 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 $2,800,000. Dr. DeMello thought there was a 75 percent probability this would happen.

Offer II: Thirty percent of the buyer's gross profit on the product for the next four years. The buyer in this case was Bayer Pharmaceutical. Bayer's profit margin was 65 percent. Sales in year one were projected to be $1,900,000 and then expected to grow by 45 percent per year.

Offer III: A trust fund would be set up for the next 9 years. At the end of that period, Dr. DeMello would receive the proceeds (and discount them back to the present at 10 percent). The trust fund called for semiannual payments for the next 9 years of $200,000 (a total of $400,000 per year). 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).

Required: Find the present value of each of the three offers and indicate which one you would recommend Dr. DeMello to choose.

Added by Fernando D.

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