At the current time, the beginning of year 0, the Baron company is trying to decide whether
Question:
At the current time, the beginning of year 0, the Baron company is trying to decide whether one of its new drugs, Saga, is worth pursuing. Naga is in the final stages of development and will be ready to enter the market one year from now. The final cost of development, to be incurred at the beginning of year 1, is $15 million. the Baron company estimates that the demand for Saga will gradually grow and then decline over its useful lifetime of 20 years. Specifically, the company expects its gross margin (revenue minus cost) to be $1.5 million in year 1, then to increase at an annual rate of 6% through year 8, and finally to decrease at an annual rate of 5% through year 20. Baron company wants to develop a spreadsheet model of its 20-year cash flows, assuming its cash flows, other than the initial development cost, are incurred at the end of the respective years. Using an annual discount rate of 7.5% for the purpose of calculating NPV, the drug company wants to answer the following questions:
1. Which has a greater present value: the gross margin for year 1 or the gross margin for year 8 (the peak year for gross margin)?
2. What is the present value of the gross margin at year 16?
3. What rate of increase is needed from year 1 through year 8 to have a year 8 gross margin with a present value that is equal to the present value of the year 1 gross margin?
