Robert Smith of Medical Research Corporation (MRC) was thrilled with the response he had received from drug companies for his latest discovery, a unique electronic simulator 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 in the following paragraph.
Offer 1:
$1,200,000 now plus $200,000 from years 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 $2,100,000. Dr. Smith thought there was a 100 percent probability this would happen. He is planning to use an 8 percent discount rate to evaluate offer 1.
Offer 2:
Thirty percent on the buyer’s gross profit on the product for the next four years. The buyer in this case was Zbay Pharmaceutical. Zbys’s gross profit margin was 60 percent. Sales in year one was projected to be $2 million and then expected to grow by 40 percent per year. He is planning to use an 8 percent discount rate to evaluate offer 2.
Which offer should Dr. Smith accept? Please explain. Hint: Find the present value of each of the two offers and indicate which one has the highest present value. (please explain findings through work shown)