Question

You are evaluating to make an investment in a small biotech start-up which will require an...

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

Homework Answers

Answer #1

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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