1. You are in inventor whose patent is used in manufacturing of a pain management drug. As a result, you are getting a stream of royalties, and your royalties will end at the time of the patent expiration 5 years from now. You collect your royalty payments at the end of each year. You expect that at the end of the current year the royalty payment will be $10,000. After that, you estimate that the growth in royalty payments to be low, at 1% per year, due to increased competition. You are considering selling your royalty payment stream, potentially to the maker of the drug, Pharma Corp., which is a large publicly traded company. Pharma Corp. is financed with both debt and equity. The market value of equity is $100M, and the book value of debt is $50M. The beta of equity is 2. The risk-free rate is 2% and the expected market risk premium is 5%. Assume that the beta of corporate debt is 0.25.

1. What discount rate should you be using if you do not have any other wealth but the stream of royalties? You estimate the volatility of the royalty cash flows to be 45% per year, and the volatility of the market returns is 20% per year.