Question

You are evaluating to make an investment in a small biotech start-up which will require an investment of $1.0 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 covered 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. $1863301

b. $2402628

c. $1896634

d. $1682223

e. $1518029

Answer 1

Present Value of cash flows can be calculated using PV function

If drug is not cover, N = 12, PMT = 400,000, FV = 0, I/Y = 20% => Compute PV = $1,775,686.69

In this scenario, the firm could sell the patent at $2,500,000 to other company.

If drug is covered, N = 12, PMT = 800,000, FV = 0, I/Y = 20% => Compute PV = $3,551,373.38

Expected Value in year 1 = 2,500,000 x 30% + 3,551,373.38 x 70% = $3,235,961.37

NPV = (3,235,961.37 + 200,000) / (1 + 20%) - 1,000,000 = $1,863,301