Reference no: EM133016266

Question - MPS Pharmaceuticals is a large drug company. One of its new drugs, Sequacor, is coming to market and MPS Pharmaceuticals needs to determine how much annual production capacity to build for this drug. Government regulations make it difficult to add capacity at a later date, so MPS Pharmaceuticals must determine a capacity recommendation before the drug comes to market. The drug will be sold for 20 years before it comes off patent. After 20 years, the rights to produce the drug are virtually worthless.

MPS Pharmaceuticals has made the following assumptions:

-The drug's demand in year 1 will be 15,000 units.

-During years 2-5, the annual growth of demand will be 10%.

-During years 6-20, the annual growth of demand will be 5%.

-It costs $5, payable at the end of year 1, to build each unit of annual production capacity.

-During year 1, Sequacor will sell for $7 per unit and will incur a variable cost of $4 to produce.

-The cost of maintaining a unit capacity during year 1 is $1.

-The sales price, unit variable cost, and unit capacity maintenance cost will increase by 3% per year.

-All cash flows are assumed to occur at the end of each year, and the corporate discount rate is 8%.

You have been hired by MPS Pharmaceuticals to develop a spreadsheet model of its 20-year cash flows.

The company would specifically like to answer the following questions.

Required -

1. What capacity level should be chosen for the production facility?

2. How does a change in the discount rate affect the optimal capacity level?

3. How realistic is the model? Is there any other aspect that should be taken into account when developing the model (e.g., uncertainty in the demand, future prices, and future costs)?