Question

You are evaluating to make an investment in a small biotech start-up which will require an investment of $1.7 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 cover 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

Let us first calculated expected cash flow for year 2 to 13

Particular	Cash flow	Probability	Expected cash flow
Insurance company will cover in plan	800000	70%	560000
Insurance company will not cover in plan	400000	30%	120000
			680000

Statement showing NPV

Year	Cash flow	PVIF @ 20%	PV
0	-1,700,000	1	-1700000
1	200000	0.8333	166667
2	680000	0.6944	472222
3	680000	0.5787	393519
4	680000	0.4823	327932
5	680000	0.4019	273277
6	680000	0.3349	227731
7	680000	0.2791	189776
8	680000	0.2326	158146
9	680000	0.1938	131789
10	680000	0.1615	109824
11	680000	0.1346	91520
12	680000	0.1122	76267
13	680000	0.0935	63555
NPV			982223

Since NPV of aborting the project i.e [(2500,000*0.3*0.8333)-1000,000] -375000 , we will continue the project

Thus NPV = $982223