Question

1.A pharmaceutical company has already spent 1 million dollars in research for a new drug and now has to make a decision. The company can either terminate the research program or it can move to the development phase. If the company moves to the development phase, it has to invest another 1 million dollars today to start producing and selling the new drug. However, once the company begins producing and selling the new drug, it expects to make 150,000 dollars at the end of each year forever.

If the opportunity cost of funds (interest rate) is 10% per year, should the company terminate the program or move to the development phase?

Answer 1

Answer:-

If the company terminates the research program it will lose the $1,000,000 which was invested in the program. The loss would be $1,000,000.

If the company does not terminate the research program, it will have to spend another $1,000,000 today and it will generate $150,000 forever. The interest rate is 10%.

The PV of the perpetuity will be = PMT / I = $150,000 / 0.10 = $1,500,000.

We have already spent $2,000,000 til the development stage of the project. And if we continue with it we will lose $500,000; which is better than the above option of terminate where we were losing $1,000,000. Hence we should move to the development stage as it reduces ours loses.