Question

New Dawn pharma is considering the acquisition of a small biotech company—Sunset Pharmaceuticals. Sunset is developing a new drug that, if successful, would revolutionize the treatment of pancreatic and/or liver cancer. Sunset is about to start Phase I of the clinical testing for the new drug. New Dawn estimates that if they acquired Sunset the costs associated with Phase I testing would be around $60 million. They believe the probability of successful Phase I testing is 30%. Phase 2 testing for the pancreatic cancer and/or liver cancer indication would cost $170 million. The probability that Phase 2 testing will show effectiveness for pancreatic cancer is 25%. The probability that Phase II will show clinical efficacy for liver cancer only is 45%. Phase 3 testing for the pancreatic cancer indication will cost $300 million. The probability that Phase 3 testing for pancreatic cancer will be successful is 40%, and the cost of launching the drug for the pancreatic indication only will be $250 million. New Dawn estimates that future cash flows from a successful pancreatic cancer indication will be in the vicinity of $10 billion. Phase 3 testing for the liver cancer indication only will cost $350 million. The probability that Phase 3 testing will show effectiveness for liver cancer is 70%, and the cost of launching the drug for the liver indication only will be $200 million. Estimates for future cash flows from a successful liver cancer launch are in the vicinity of $20 billion. (All cash flows are expressed in after-tax present values discounted to time zero, including capital expenditure.)

A. What is the NPV of Sunset’s new drug line? Based on this estimate, should New Dawn pursue the acquisition? Show all your work.

Answer 1

	Probability of Success for Pancreatic Cancer	0.03	(0.3*0.25*0.4)
	Probability of Success for Lever Cancer	0.0945	(0.3*0.45*0.7)
	Common Cost =60million+170million	230	million
	Additional Cost for Pancreatic Cancer=300+250	$550	million
	Additional Cost for Lever Cancer=350+200	$550	million
	Total Cost	$1,330	million
	CASH INFLOWS
		Probability	Cash Flow($ million)	Probability*Cash Flow
	Pancreatic Cancer	0.03	$10,000	$300
	Lever Cancer	0.0945	$20,000	$1,890
			SUM	$2,190
	EXPECTED CASH INFLOW	$2,190	million
	CASH OUTFLOWS	($1,330)	million
	Net Present Value(NPV)=2190-1330=	$860	million
	NPV is positive
	New Dawn should pursue the acquisition