Time Value of Money

East Worcester Medical Apparatus Company

The Time Value of Money

Dr. Miller of the East Worcester Medical Apparatus Company was thrilled with the response she had received from two medical product manufacturers for her latest discovery, a unique electronic pulsar that reduces the pain from arthritis. The product is still in early stage testing, but the interest was apparent. She received firm offers to buy the rights to production from the two companies described below.

Offer I. The buyer in this case was Smythe Manufacturing. They offered Dr. Miller $2 million now plus $100,000 each year beginning at the end of year six and continuing through the end of year fifteen.

You are Dr. Miller’s financial advisor and you feel that given the associated risks to this payment stream, a 10% interest (discount) rate should be used to determine the present value of the offer.

Offer II. The buyer in this case was Brouwer Pharmaceutical. They offered 40 percent of their gross profit on the product for the next four years, with payments beginning at the end of the first year. Brouwer’s gross profit margin was 60%. Sales in year one were projected to be $3 million and are forecasted to grow by 30 percent each year thereafter.

You are Dr. Miller’s financial advisor and you feel that given the associated risks to this payment stream, an 8% interest (discount) rate should be used to determine the present value of the offer.

Instructions:

Please prepare 1 – 1 ½ page written memorandum recommending either Offer I or Offer II above. The recommendation must be for the highest present value based upon your calculations. Dr. Miller has no idea what present value is or how it can be used to value the two offers. The memorandum must include a brief explanation of the present value concept and an explanation as to why the two discount (interest) rates differ. Do not write a memo that explains the calculations, write a memo that explains the concept. Use full sentences in a paragraph format and attach a separate sheet with your present value calculations.