Corporate Finance

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Corporate Finance

A typical B-E chart is shown in Exhibit 11.5. Financial BEP refers to the level of activity at which
NPV = 0. At that level, Present value of revenues = Present value of costs. Since at any level below the
BEP the company will be financially worse off, BEP serves as a useful check.

Exhibit 11.5 Break-even chart

Break even point Sales

Variable costs

Fixed cost

No. of units sold

Rs

DECISION TREES

Pharmaceutical companies like Merck typically license drugs from smaller companies. Under the agreement,
the pharmaceutical company is responsible for the approval of the drug from the concerned authorities, its
manufacture and its marketing. The company pays an initial fee and a royalty on all sales, and makes additional
payments as the licensor completes each stage of the approval process. In the US, each drug goes through a
three-phase approval process as shown here:

Phase I Phase II Phase III

Test for safety Testing for effectiveness Testing for safety and efficacy

(Small number of patients) and side effects (Much larger)

(Larger number)

The whole process takes about 7 years to complete.
There is 60 percent, 10 percent, and 85 percent chance that the product will successfully complete phases
1, 2, and 3 respectively.
Consider another business situation. The management of a company must decide whether to build a small
plant or a large plant to manufacture a new product with an expected market life of 10 years. The decision
depends on what the market size will be for the new product.
The demand for the product could be:

• High during the first two years and then drop off to a low level if customers do not find the product
  satisfactory.


• High followed by sustained high demand if the product is well accepted.


• Low during the introductory period in which case the company can abandon the project.

The company has three options: