Question

Approximately 14 million Americans are addicted to drugs and alcohol. The federal government estimates that these addicts cost the U.S. economy $300 billion in medical expenses and lost productivity. Despite the enormous potential market, many biotech companies have shied away from funding research and development (R&D) initiatives to find a cure for drug and alcohol addiction. Your firm – Drug Abuse Sciences (DAS) – is a notable exception. It has spent $185 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $40 million today. Unfortunately, the firm’s opportunity cost of funds is 9 percent and it will take another five years before final approval from the Federal Drug Administration is achieved and the product is actually sold. Expected (year-end) profits from selling the drug are presented in the accompanying table.

Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9
$0	$0	$0	$0	$10,600,000	$12,300,000	$14,100,000	$15,800,000	$18,200,000

What is the net present value of the project?

Instruction: Enter your response rounded to the nearest penny (two decimal places). Use a negative sign (-) where appropriate.

$

Should DAS continue with its plan to bring the drug to market, or should it abandon the project?

(Click to select)  Continue  Abandon

Answer 1

All cash outflows have a negative sign and all cash inflows have a positive sign.

Example, there is an outflow of 185 million and needs another outflow of 40 million , hence they will have a negative sign in the Net present value or NPV calculation as shown below.

All cash inflows from sales from 5th year onwards will have positive sign and will be dicounted by a factor of 9%, which is opportunity cost of funds.

Net present value(NPV) of the project = - 185million - 40 million + ( 10.6 million/1.09⁵) +( 12.3 million/1.09⁶) + ( 14.1 million/1.09⁷​​​​​​​) + ( 15.8 million/1.09⁸​​​​​​​) + ( 18.2 million/1.09⁹​​​​​​​)

= - 185million - 40 million + 6.89 million + 7.33 million + 7.71 million + 7.93 million + 8.38 million

= - 186.76 million(in dollars)

DAS should continue to bring the drug to market inspite of a negative NPV of the project because the drug can be used by 14 million Americans(huge market potential) for years to come and save 300 billion dollars in medical expenses and lost productivity for the US economy. NPV calculated is only for a 9 year time horizon while the drug sales will continue for years to come and NPV will be positive for a longer time horizon.