Question

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 $60 million today. Your opportunity cost of funds is 5%; 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. Should D&S continue with the plan to bring the drug to market or should it abandon its plan? Discuss the relevance, if any, of the $200 million expenditure, to the decision to continue with the program.

Year 1             $0

Year 2             $0

Year 3             $0

Year4              $0

Year 5             $12million

Year 6             $13.4 million

Year 7             $17.2 million

Year 8             $20.7 million

Year 9             $22.45 million

Answer 1

Spending of $200 million has already been spent and cannot be recovered based on future decisions, so this is a sunk cost and is not considered in the cash flow analysis.

Present Worth (PW) is computed as follows.

Year	Cash Flow ($ Million)	PV Factor @5%	Discounted Cash Flow ($ Million)
	(A)	(B)	(A) x (B)
0	-60	1.0000	-60
1	0	0.9524	0
2	0	0.9070	0
3	0	0.8638	0
4	0	0.8227	0
5	12	0.7835	9.40
6	13.4	0.7462	10.00
7	17.2	0.7107	12.22
8	20.7	0.6768	14.01
9	22.45	0.6446	14.47
		PW ($ Million) =	0.11

Since PW > 0, the program should be continued.