Life Products Inc. is s a small pharmaceutical company that has developed a drug that treats immune disorders. The drug has been approved for use and has 15 years left of its patent life. The company is considering two mutually exclusive options:
Invest $750 million in capital, depreciable straight line over 15 years to a salvage value of zero, and produce the drug itself. The drug is expected to generate $ 90 million in after-tax operating income each year for the 15 years.
License the drug to Pfizer and receive a fixed licensing fee each year from Pfizer. There will be no initial investment and the only risk that Life Products faces is that Pfizer may default.
You are provided with the costs of debt, equity and capital for both Life Products and Pfizer in the table below:
|
Pre-tax cost of debt
|
After-tax cost of debt
|
Cost of equity
|
Cost of capital
|
|
Life Products
|
8.00%
|
4.80%
|
14.00%
|
12.50%
|
|
Pfizer
|
5.00%
|
3.00%
|
9.00%
|
7.50%
|
a. Assuming that Life Products invests $750 million in capital and produces the drug itself, what NPV would you estimate for the investment?
b. What annual licensing fee would Pfizer have to offer Life Products for the licensing deal to create more value for Life Products than Health Products producing the drug itself?