Question

• Opportunity A: a "me-too" oncology drug currently in Phase 3 clinical trials that requires a $100 million investment today (year 0), and if successful, provides annual profits of $100 million over its remaining 10 year patent starting in year 3 (otherwise it returns nothing). Suppose the probability of success is 50%.
• Opportunity B: a combination therapy of blinatumomab and chemotherapy designed to cure acute lymphoblastic leukemia that requires a $200 million investment today (year 0), and if successful, provides annual profits of $2 billion over its remaining 10 year patent starting in year 11 (otherwise it returns nothing). Suppose the probability of success is 5%.

A) What are the expected annual cash flows of opportunity A for years 3 to 12? (Note: Your answer should be expressed in units of millions of dollars.)

Expected annual cash flow = $___ million

B) What are the expected cash flows of opportunity B for years 11 to 20? (Note: Your answer should be expressed in units of millions of dollars.)

Expected annual cash flow = $____ million

C) Suppose we calculate the NPV of each opportunity by discounting the expected cash flows. Assume a discount rate of 12% per year for opportunity A, and 20% per year for opportunity B. What is the NPV of each opportunity? (Note: Your answer should be expressed in units of millions of dollars.)

NPV opportunity A = $____ million

NPV opportunity B = $____ million

Answer 1

Solution:-

(A)

Expected annual cash flows= Annual cash flows*probability of success

Therefore, using the above formula, we get as below

Expected annual cash flows= $100m*50% = $50 million

(B)

Expected annual cash flows= Annual cash flows*probability of success

Therefor, using the above formula, we get as below

Expected annual cash flows= $2,000m*5% = $100 million

(C)

Discount rates are 12% for A and 20% for B.

NPV (Opportunity A)=Expected annual cash inflow*Sum of PV factors for 10 years (Year 3 to Year 12) - Initial investment*PV Factor (Year 0)

PV factor (Year 0)= 1

Sum of PV factor (Year 3 to Year 12)= 1/(1.12)³ + 1/(1.12)⁴ + 1/(1.12)⁵ + 1/(1.12)⁶...……..+ 1/(1.12)¹² = 4.504

NPV (Opportunity A)= $50m*4.504 - $100m*1 = $125.2m

NPV (Opportunity B)=Expected annual cash inflow*Sum of PV factors for 10 years (Year 3 to Year 12) - Initial investment*PV Factor (Year 0)

PV factor (Year 0)= 1

Sum of PV factor (Year 3 to Year 12)= 1/(1.2)³ + 1/(1.2)⁴ + 1/(1.2)⁵ + 1/(1.2)⁶...……..+ 1/(1.2)¹² = 2.911

NPV (Opportunity A)= $100m*2.911 - $200m*1 = $91.1m