A pharmaceutical company makes a single drug, XYZ, for which the patent expires in four years. After the patent expires, the company will earn no more economic profits after the fourth year passes because 1) dozens of firms will produce a generic version of XYZ that will drive the price of XYZ down to unit costs, and 2) it has invested nothing in research and development of new drugs and so will have no new sources of profit when the patent on XYZ expires in four years.
You work as a research assistant for an investment-banking firm that specializes in acquisitions of pharmaceutical firms. After examining the financial statements of the company, you predict that it will earn $23 million in economic profit in EACH of the next four years, after which, it will earn zero economic profit. Your job is to advise a potential buyer of the drug firm on the market value of this firm. You believe 12 percent is the appropriate risk-adjusted discount rate for valuing the company.
a. What kind of advice do you give to a potential buyer regarding the value of the company?
b. Newly released information indicates that conditions in the market for drugs is likely to deteriorate in the near future. Does the information change the nature of your advice? If so, in what way?