Question

Young Pharmaceuticals is considering a drug project that costs $2.42 million today and is expected to generate end-of-year annual cash flows of $211,000 forever. At what discount rate would the company be indifferent between accepting or rejecting the project?

Answer 1

At 8.72% the company would be indifferent between accepting or rejecting the project

Step-by-step explanation:

To be indifferent to accepting or rejecting the project, the initial cost of the project should equal the present value of all expected cash inflow to the project i.e. the Break-even point which is the point at which revenue = cost, thereby generating zero profit.

From the question, Young Pharmaceuticals is investing $2.42 million and expects an annual year end cash flow of $211,000 forever. We therefore apply the annuity to perpetuity formula

PV of perpetuity = Periodic cashflow/interest rate

cross multiply and make Interest the subject of the formular

= Interest = Periodic cashflow/PV of perpetuity

i = 211000/2420000

= 0.0872

= 8.72%