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?”

Answer 1

In case drug is approved

NPV = 2126144.48  

pROBABILITY = 0.7

Net NPV = 1488301.14

In case drug is not approved

NPV = 902777.78

Probability = 0.3

Net NPV = 270833.33

tOTAL NPV = 1488301.14 + 270833.33 = 1759134.47

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