Question

Akba Pharma has just completed the laboratory research on a new drug which is expected to cure boredom. So far, $100 million has been spent on research and development.

Before the investment in plant, the drug will now be tried on volunteers. This phase will cost a further $200 million. The chances of a positive result from this phase are 50%. If the results are positive, Akba will receive a patent and will start producing the drug in a new factory. If the results are negative Akba will terminate the project and will not make the investment in plant.

The cost of investment in the new factory is $500 million. The factory investment will be depreciated over 5years to a book value of zero. The patent of the boredom drug will expire after 5 years. After the patent expires, the production of the drug will no longer be profitable for Akba and production will be stopped. The factory however will be sold for $100 million.

Variable production costs are expected to be 20% of sales. Working capital required for each year is expected to be 20% of next year's revenues. Akba Pharma expects the following sales revenues from the boredom new drug.

                       Revenues ($million)

Year1                            300

Year2                            500

Year3                           700

Year4                           700

Year5                           500

The tax rate for Akba Pharma is 30%. The cost of capital for this project is 15%.

Please show all your work. (You can submit an excel file or an image if you work on paper)

a. Describe how you would treat the cost of $200 million of product testing on volunteers. 

b. Calculate for each year of the project the total cash flows (Cash flows from operations, cash flows of capital investment and cash flows of investments in working capital investments).

c. Calculate the expected net present value of the project.

Answer 1

A)

I would treat the cost of $200 million of product testing on volunteers as sunk cost. Hence, irrelevant in decision making. (Sunk cost - cost that have already been incurred and cannnot be recovered). Product testing on Volunteers is a sunk cost because it was incurred before the project was accepted.

 

B) & C) refer the image attached below: