You are evaluating to make an investment in a small biotech start-up which will require an investment of $2.5 million. The start-up is expecting to generate free cash flows of $200,000 during the first year.
After one year, the insurance companies will decide if the start-up’s drug will be cover in their plans or not. If they decide to not cover the drug, the company will be able to generate free cash flows of $400,000 during the next 12 years (the period of the patent) and zero after that. If the insurance companies decide to cover the drug, the start-up will be able to generate free cash flows of $800,000 during the next 12 years (the period of the patent) and zero after that.
Furthermore, the start-up can also decide to sell the patent to a larger biotech company for $2.5 million after knowing the answer of the insurance companies (end of year 1), whether they cover it or not. You expect that the insurance companies will approve the drug with a 70% probability and you require a 20% return.
What is the NPV of the investment?”
Select one:
a. $396634
b. $18029
c. $902628
d. $182223
e. $363301
Let us first calculated expected cash flow for year 2 to 13
Particular | Cash flow | Probability | Expected cash flow |
Insurance company will cover in plan | 800000 | 70% | 560000 |
Insurance company will not cover in plan | 400000 | 30% | 120000 |
680000 |
Statement showing NPV
Year | Cash flow | PVIF @ 20% | PV |
0 | -2,500,000 | 1 | -2500000 |
1 | 200000 | 0.8333 | 166667 |
2 | 680000 | 0.6944 | 472222 |
3 | 680000 | 0.5787 | 393519 |
4 | 680000 | 0.4823 | 327932 |
5 | 680000 | 0.4019 | 273277 |
6 | 680000 | 0.3349 | 227731 |
7 | 680000 | 0.2791 | 189776 |
8 | 680000 | 0.2326 | 158146 |
9 | 680000 | 0.1938 | 131789 |
10 | 680000 | 0.1615 | 109824 |
11 | 680000 | 0.1346 | 91520 |
12 | 680000 | 0.1122 | 76267 |
13 | 680000 | 0.0935 | 63555 |
NPV | 182223 |
Since NPV of aborting the project i.e [(2500,000*0.3*0.8333)-1000,000] -375000 , we will continue the project
Thus Ans d) $182223
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