You work for a pharmaceutical company that has developed a new drug. The patent

Question

You work for a pharmaceutical company that has developed a new drug. The patent on the drug will last 17 years. You expect that the drug's profits will be $4 million in its first year and that this amount will grow at a rate of 6% per year for the next 17 years. Once the patent expires, other pharmaceutical companies will be able to produce the same drug and competition will likely drive profits to zero. What is the present value of the new drug if the interest rate is 10% per year? The present value of the new drug is S million. Round to three decimal places.)

Explanation / Answer

The present value of the new drug is sum of discounted expected profit from the drug over 17 years

First let’s project the expected profit from the drug for 17 years where expected profit for first year is $4 million and annual growth rate is 6%.

Year

Expected Profit (Million)

1

$4.00

2

$4.24

3

$4.49

4

$4.76

5

$5.05

6

$5.35

7

$5.67

8

$6.01

9

$6.38

10

$6.76

11

$7.16

12

$7.59

13

$8.05

14

$8.53

15

$9.04

16

$9.59

17

$10.16

Where, Formula used is Expected profit of previous years *(1+6%)

Now we have to discount Expected profit from drug to its present value at discount rate of 10% in following manner –

Therefore the present value of the new drug is $46.725 million

Year

Expected Profit (Million)

1

$4.00

2

$4.24

3

$4.49

4

$4.76

5

$5.05

6

$5.35

7

$5.67

8

$6.01

9

$6.38

10

$6.76

11

$7.16

12

$7.59

13

$8.05

14

$8.53

15

$9.04

16

$9.59

17

$10.16

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