Question

You are the CFO of a large, Danish company that produces and sells medicine. You are appointed by the board of directors to serve the shareholders interest. As the CFO, you are considering to invest in the development of a new drug called Lifesaver. The cost of developing the drug is DKK 5,000,000 in present value terms. It will take ten years for the drug to be developed. There is only a 30% chance that the drug will work and be approved. If it does not work, it will not generate any profits. If it works, it will generate DKK 3,000,000 per year for 10 years, after which the patent to the drug will expire and it will become impossible to make a profit on the drug (that is, the patent will allow you to make money on the drug in years 11- 20). The discount rate is 8%.

a. What is the NPV of investing in the drug? Should you make the investment?

b. A friend of yours argues that your NPV analysis is unnecessary: you should make the investment regardless of whether it is profitable for your firm or not, because it might still help save people’s lives, which is ultimately more important than money. What would you tell him/her?

Answer 1

Cost of Developing Drug at present = DKK 5000000, Discount Rate = 8 %, Annual Income Generated (from year 11-20) = DKK 3000000

PV of money generated by the drug at the end of year 10 = 3000000 x (1/0.08) x [1-{1/(1.08)^(10)}] = DKK 20130244.2

PV of money generated at the end of year 0 = 20130244.2 / (1.08)^(10) = DKK 9324198.026

Probability of Success = 0.3

Expected PV = 9324198.026 x 0.3 = DKK 2797259.408

Expected NPV = 2797259.408 - 5000000 = - DKK 2202740.59

As the NPV is negative, one should not invest.

(b) It would be important to note that an NPV analysis is purely a form of financial analysis and disregards the moralistic perspectives of an investment decision. Hence, it would be unwise to invest in the drug from a purely financial standpoint.