Question

You are evaluating to make an investment in a small biotech start-up which will require an investment of $2.1 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. $796634

b. $582223

c. $763301

d. $1302628

e. $418029

Answer 1

There is common cash flow for both options whether its approved or not in initial investment
and first year that is
	Year	Cash flow	x DF at 20%	= Present value
	0	$       (2,100,000)	1	$ (2,100,000.00)
	1	200000	0.833333333	166,666.67
				$ (1,933,333.33)
And after first year, there is some probabilty of approval 70%, and no approval 30%
So suppose there is approval
	Year	Cash flow	x DF at 20%	= Present value
	2	800000	0.694444444	555555.5556
	3	800000	0.578703704	462962.963
	4	800000	0.482253086	385802.4691
	5	800000	0.401877572	321502.0576
	6	800000	0.334897977	267918.3813
	7	800000	0.279081647	223265.3178
	8	800000	0.232568039	186054.4315
	9	800000	0.193806699	155045.3596
	10	800000	0.161505583	129204.4663
	11	800000	0.134587986	107670.3886
	12	800000	0.112156655	89725.32383
	13	800000	0.093463879	74771.10319
				$    2,959,477.82	x 70% probability
		Present value	=	$    2,071,634.47
Ans , there is n approval
Here again there is two options with company, sell at end of first year
or continue with lower cash flow for 12 years , and options with higher present value will be continued
	Year	Cash flow	x DF at 20%	= Present value
	2	400000	0.694444444	277777.7778
	3	400000	0.578703704	231481.4815
	4	400000	0.482253086	192901.2346
	5	400000	0.401877572	160751.0288
	6	400000	0.334897977	133959.1907
	7	400000	0.279081647	111632.6589
	8	400000	0.232568039	93027.21574
	9	400000	0.193806699	77522.67979
	10	400000	0.161505583	64602.23316
	11	400000	0.134587986	53835.1943
	12	400000	0.112156655	44862.66191
	13	400000	0.093463879	37385.55159
				$    1,479,738.91	x 30% probability
		Present value	=	$       443,921.67
For sell at end of first year
	Cash flow	2500000
	Present value	$       625,000.00	(2500000/1.2)
So present value of sell at end of 1 year is higher and woyld be selected
	Now come to Total net present value
	Common	$ (1,933,333.33)
	70% probability	$    2,071,634.47
	30% probability	$       625,000.00
	Net present value	$             763,301	Option C , is NPV of investment