Question

In: Finance

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

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 covered 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. $418029 b. $582223 c. $763301 d. $796634 e. $1302628

Solutions

Expert Solution

Let us calculate the PV of cash flows for each possibility

PV Factor = 1/(1+r)n, where r is the required rate of return and n is the year

PV = CFn*PV Factor

Case 1 - Drug Not Covered (p = 0.30)

Year Cash Flow PV Factor PV
0 -2100000 1.00 -2100000.00
1 200000 0.83 166666.67
2 400000 0.69 277777.78
3 400000 0.58 231481.48
4 400000 0.48 192901.23
5 400000 0.40 160751.03
6 400000 0.33 133959.19
7 400000 0.28 111632.66
8 400000 0.23 93027.22
9 400000 0.19 77522.68
10 400000 0.16 64602.23
11 400000 0.13 53835.19
12 400000 0.11 44862.66
13 400000 0.09 37385.55
NPV -453594.42

Case 2 - Drug Covered (p = 0.70)

Year Cash Flow PV Factor PV
0 -2100000 1.00 -2100000.00
1 200000 0.83 166666.67
2 800000 0.69 555555.56
3 800000 0.58 462962.96
4 800000 0.48 385802.47
5 800000 0.40 321502.06
6 800000 0.33 267918.38
7 800000 0.28 223265.32
8 800000 0.23 186054.43
9 800000 0.19 155045.36
10 800000 0.16 129204.47
11 800000 0.13 107670.39
12 800000 0.11 89725.32
13 800000 0.09 74771.10
NPV 1026144.48

Hence, NPV = 0.30 * NPV(Case 1) + 0.70 * NPV(Case 2) = 0.30(-453594.42) + 0.70(1026144.48) = $582222.81

Hence, the correct option is (b) $582223


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