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?” Select one: a. $1196634 b. $982223 c. $818029 d. $1702628 e. $1163301

Answer 1

Final answer

NPV of the Investment = $ 1,163,301 ............. Option - (e)

Explanation

Let us understand the question

First year cash flow = 200,000.

AND

From 2nd year to 13th Year ( i.e next 12 years ) ............ 400,000 ......... if Insurance DOES NOT approved the drug

Or

Sell the patents for 2500,000 at the end of Year - 1 ....... which makes a total cash for Year - 1 = 200,000 + 2500,000

= 2700,000............................................................................................. if insurance DOES NOT approve the drug.

Or

From 2nd year to 13th Year ( i.e next 12 years ) ............ 800,000 ......... if Insurance approves the drug

As seen from above calculation we have Alternative (Alt - 1 and Alt - 2). So our choice is Alt - 2 if drug is not approved.

It had a probability of 30%.

So Expected NPV of this project = 550,000 * 30% + 1426144 * 70% = $1,163,301 .............. Option - e