Question

Despite an enormous potential market, many Biotech companies have shied away from R&D funding related to drug and alcohol addiction. Your firm, D&S, is a notable exception. It has spent 200 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $80 million today. Your opportunity cost of funds is 10%; unfortunately, it will take another five years before final approval from the Food and Drug Administration is achieved and the product is actually sold. Expected year–end profits are shown in the following diagram. Be sure to incorporate the $200 million expenditure into your analysis appropriately. Should D&S continue with the plan to bring the drug to market or should it abandon its plan? Answer the question using the data below. Explain your reasoning fully and the Economic meaning of your numerical answer.

Year 1                 $0

Year 2                 $0

Year 3             $0

Year4              $0

Year 5             $12million

Year 6             $13.4 million

Year 7             $16.2 million

Year 8             $19.7 million

Year 9             $25.45 million

Answer 1

The $200 million expenditure has been spent to find a cure that is a sunk cost, since it cannot be recovered whether or not the company decides to go ahead in future. So this expense is excluded from the decision-making process.

Net Present Value (NPV) of the cash flows is computed as follows.

Year	Cash Flow ($ Million)	PV Factor @10%	Discounted Cash Flow ($ Million)
	(A)	(B)	(A) x (B)
0	-80	1.0000	-80
1	0	0.9091	0
2	0	0.8264	0
3	0	0.7513	0
4	0	0.6830	0
5	12	0.6209	7.45
6	13.4	0.5645	7.56
7	16.2	0.5132	8.31
8	19.7	0.4665	9.19
9	25.45	0.4241	10.79
		NPV ($ Million) =	-36.69

Since NPV < 0, the plan should be abandoned.