Question

Excel to do the calculations. Be sure to write clear steps for your derivations.

5. (25 points) 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 $8.25 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 $4.15 per package in real terms for the headache-only brand. Production costs are expected to be $4.55 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 3 percent. Either product requires further investment. The headache-only pill could be produced using equipment costing $22 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 percent and believes that the appropriate real discount rate is 7 percent. Which pain reliever should the firm produce?

Answer 1

Headache only Pill Selling Price after Discount = $8.25 - (7/100 * $8.25) = 7.6725  
Total Units to be sold of Headache only Pill = 3 Million
Headache only Pill Cost for the 1st year = $4.15
Headache only Pill Cost for the 2nd Year = $4.15 * 1.03 (Inflation) = $4.27
Headache only Pill Cost for the 3rd Year = $4.15 * 1.03 * 1.03 = $4.40
Income for the 1st Year = ($7.6725 * 3 Million) - ($4.15 * 3 Million) = $10.57 Million
Income for the 2nd Year = ($7.6725 * 3 Million) - ($4.27 * 3 Million) = $10.20 Million
Income for the 3rd Year = ($7.6725 * 3 Million) - ($4.40 * 3 Million) = $9.82 Million
Total Income = ($10.57 Million + $10.20 Million + $9.82 Million ) - Cost of Machinery($22 Million) = $8.59 Million
Tax on Income of 34% = ($8.59) * (34/100 * $8.59 Million)
Net Income = $5.67 Million

Headache and arthritis Pill Selling Price = $8.25 - (7/100 * $8.25) = 7.6725
Total Units to be sold of Headache and arthritis Pill = 4.5 Million
Headache and arthritis Pill Cost for the 1st year = $4.55
Headache and arthritis Pill Cost for the 2nd Year = $4.55*1.03 = $4.69
Headache and arthritis Pill Cost for the 3rd Year = $4.55*1.03*1.03 = $4.83
Income for the 1st Year = ($7.6725 * 4.5 Million) - ($4.55 * 4.5 Million) = $14.05 Million
Income for the 2nd Year = ($7.6725 * 4.5 Million) = ($4.69 * 4.5 Million) = $13.43 Million
Income for the 3rd Year = ($7.6725 * 4.5 Million) = (4.83 * 4.5 Million) = $12.79 Million
Total Income = ($14.05 Million + $13.43 Million + $12.79 Million) - Cost of Machinery ($32 Million) + Resale Value of Machine ($1 Million) = $9.27 Million
Tax on Income of 34% = $9.27 Million * (34/100 * 9.27 Million)
Net Income = $6.12 Million

So the company should produce Headache and arthritis Pill as the profit is Higher as Shown in the above Calculations.