Dr. Harold Wolf of Medical Research Corporation (MRC) discovered a unique electronic stimulator that is said to have the capability of reducing the pain from arthritis. Even though the Federal Drug Administration (FDA) still has to approve the device, and the testing is in the early stages, the interest generated is powerful. Dr. Wolf has received three offers from interested parties and needs to decide which offer would make the most business sense. Offer One includes additional monetary incentives depending on the success of the device, Offer Two proposes a percentage of profits that would increase as sales are expected to increase and the final offer is the setup of a trust fund in an annuity over the next eight years. For discussion purposes here, each offer will be calculated to find the present value and then summarized; the offer with the highest present value will be identified for Dr. Wolf to review.
Offer OneIn this offer, Dr. Wolf is expecting a future value of $4,200,000 in 15 years at a 10% interest rate, in which the probability of the expected future value is 70%. The numbers used in getting the future value is to add the present values of $1,000,000, $200,000, and $3,000,000. The present value for the first offer is $1,005,446.61 which is an increase of $3,194,553.40 for the future and since this calculation has a 70% probability of happening, the first offer would be a good decision. See the calculations below:FV=1,000,000 + 200,000 + 3,000,000 =$4,200,000N =15I =10%PV=$8,974,419.42Offer TwoIn this offer, 30% of the buyer’s gross profit on the product for the next four years is the incentive Dr. Wolf must decide on. Zbay Pharmaceuticals would be the buyer whose gross profit margin was 60%.
If offer two were accepted by Dr. Wolf, his future value after just four years would have amassed approximately $3,138,300. This value assumes that he did not withdraw his profits and let the balance sit and gain 10% interest on the balance of the money and that sales grew by 40% in each of the subsequent years as anticipated by Zbay. Waiting till the fourth year to withdraw funds allowed the unused balance to compound interest payments. In general, this would be a good decision for the Dr. to accept, even considering the tax consequence that he would assume at the end of the four years. With the product not being approved by the FDA, Zbay Pharmaceutical has assumed all the risk which makes the offer even more lucrative.
PV:2,000,000 the first year and 40% Growth each additionalFV: $5,488,000N: 4 yearsPV Profits: $360,000 year times 10%interest ($396,000)I: 10%FV Profits: $3,138,300Offer ThreeFor Offer three, Dr. Wolf may opt for a trust fund over the next eight years. Once that period was over, he would receive the proceeds discounted back to the present at 10%. At that time, he would receive semi-annual payments in the amount of $400,000 per year beginning immediately in an annuity due. This may be a worthwhile option to consider depending on the future business plan Dr. Wolf has. This would make the present value $1,721,216. The chart is shown below.
Periods: 12 3 4 5 67 8$400,000 400,000 400,000 400,000 400,000 400,000 400,000 400,000Present Value (PV) = $1,721,216Highest Present Value and ReasoningPresent value is the value on a specific date of a payment or payments in the future that have been calculated to show the time value of money as well as other factors. These calculations are used industry wide as a method of the comparison of cash flows at different intervals over the life of the project. The basic present value formula is: PV=FV∙PVIF(r, n). The formula for an annuity is similar: PV=PMT∙PVIFA(r, n). In that case, n=number of periods, r=interest rate in the period, PV=present value at the beginning and FV=future value at time n. There are many financial arrangements that are set up with structured payment schedules and the term annuity is used to refer to that set up.
A stream of cash flow that has a limited number of payments periodically that are to be received at given times is an annuity. If the payments were to be received indefinitely, then it would be perpetuity (Block, 2005). Based on this information, Offer I has the highest present value at $8,974,419.42At first glance, it is difficult to determine which offer might be the most beneficial offer for Dr. Wolf to choose. The first offer includes additional incentives relating to the success of the device, the second offer a percentage of profits also relating to the success of the device, while the third is an annuity in trust over the next eight years.
Offer One has a present value of $8,974,419.42, Offer Two has a total present value of $2,524,713 and Offer Three has a total present value of $1,721,216. Given that Offer One of Dr. Wolf expecting a future value of $4,200,000 in 15 years at a 10% interest rate, in which the probability of the expected future value is 70%, this would be the most advantageous offer for him to accept.
Block, Stanley B., Hirt, Geoffrey A., Foundations of Financial Management (11th ed.),Irwin/McGraw-Hill, 2005, Burr Ridge, IL.