Question

Cee-ing Eye Corp. needs to decide whether to invest in research on a new drug that would instantly and painlessly cure most eyesight problems. Investing in research on the drug is estimated to cost $6 million to be paid immediately. If it decides to invest in research, the probability of technical success is 0.46. If Cee-ing Eye Corp. has technical success, it can choose between a basic or aggressive marketing strategy. A basic marketing strategy will cost the firm $2 million, and an aggressive marketing strategy will cost $9 million. The cost of the marketing strategy will be incurred in year 3. An aggressive marketing strategy has a 0.81 probability of success, and a basic marketing strategy has a 0.63 probability of success. The net cash flow given marketing and technical success will be $92 million in year 4. The net cash flow with no marketing success but with technical success will be $15 million in year 4. If there is no technical success, there is no other cash flow expect for the immediate cost of investing in research. If Cee-ing Eye decides not to invest in research, its net present worth (NPW) equals $0. You should assume the cash flow is $0 in each year except for years 0, 3, and 4. Cee-ing Eye Corp. will choose the alternative with the largest expected NPW, and its MARR is 18%. What is the expected NPW of the optimal alternative? Express your answer in MILLIONS of dollars. In other words, if the correct answer is $12.3 million, enter 12.3.

Answer 1

We will have to consider different alternatives in front of the Cee-ing Eye Corp. The alternatives are listed below:

a. Technical Success with Marketing Success (Basic Strategy)

b. Technical Success with Marketing Success (Advanced Strategy)

c. No Technical Success

Alternative a.

NPV of Cash outflows = $6 Mn (Year 0) + $9 Mn * 0.609 (Year 3) [PV Factor of 3 years at MARR 18%)

= $6 Mn (Year 0) + $5.481

= $11.5481 Mn

NPV of Cash Inflows = $92 Mn (Year 4)

Effective NPV After considering Probability of Success = $92 Mn * 0.81

= $74.52

Present Value of Cash Inflows = $74.52*0.515 (PVF of 4 Years @ 18%)

= $38.38 Mn

Net Present Worth = $38.38Mn - $11.55 Mn

= $26.83 Mn

Alternative B

NPV of Cash outflows = $6 Mn (Year 0) + $2 Mn * 0.609 (Year 3) [PV Factor of 3 years at MARR 18%)

= $6 Mn (Year 0) + $1.218

= $7.12 Mn

NPV of Cash Inflows = $15 Mn (Year 4)

Effective NPV After considering Probability of Success = $15 Mn * 0.63

= $9.45

Present Value of Cash Inflows = $9.45*0.515 (PVF of 4 Years @ 18%)

= $4.87 Mn

Net Present Worth = $4.87Mn - $7.12 Mn

= - $2.25 Mn

Alternative C.

NPV of Cash outflows = $6 Mn (Year 0)

Net Present Worth = $0 Mn - $6 Mn

= -$6 Mn

Optimal Alternative is to Follow Aggressive Strategy and NPW for the same is $26.83 Mn