Question

A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved.

NPC will proceed with the investment today to take advantage of the untapped market potential and at the end of the projects life, after finding out about the FDA,s decision about the demand for competitors product, they will decide wether or not to renew the patent and return the project. The project return's up-front cost (at t=7) will remain at $1,500, and the subsequent cash flows will remain unchanged and will be recieved for seven additional years (t=8...14). They will only return the project if the return of the project adds value.  

Assuming that all cash flows are discounted at 10%, what is the NPV of the project with and without growth option?

Answer 1

1. NPV without Growth Option

			Good Scenario (75%)		Worse Scenario (25%)
Year	PV Factors		Cash Flows	PV	Cash Flows	PV
0	1		-1500	-1500	-1500	-1500
1	0.9090909		500	454.55	25	22.73
2	0.8264463		500	413.22	25	20.66
3	0.7513148		500	375.66	25	18.78
4	0.6830135		500	341.51	25	17.08
5	0.6209213		500	310.46	25	15.52
6	0.5644739		500	282.24	25	14.11
7	0.5131581		500	256.58	25	12.83
NPV				934.21		-1378.29

Expected NPV = NPV * Probability = ($934.21*75% + (-1378 * 25%)) = $356.157

2. NPV with Growth Option

			Good Scenario (75%)		Worse Scenario (25%)
Year	PV Factors		Cash Flows	PV	Cash Flows	PV
0	1		-1500	-1500	-1500	-1500
1	0.90909		500	454.55	25	22.73
2	0.82645		500	413.22	25	20.66
3	0.75131		500	375.66	25	18.78
4	0.68301		500	341.51	25	17.08
5	0.62092		500	310.46	25	15.52
6	0.56447		500	282.24	25	14.11
7	0.51316		(500 + (-1500)	-513.16	(25 + (-1500)	-756.91
8	0.46651		500	233.25	25	11.66
9	0.42410		500	212.05	25	10.60
10	0.38554		500	192.77	25	9.64
11	0.35049		500	175.25	25	8.76
12	0.31863		500	159.32	25	7.97
13	0.28966		500	144.83	25	7.24
14	0.26333		500	131.67	25	6.58
NPV				1413.61		-2085.57

Expected NPV = NPV * Probability = ($1413.61*75% + (-2085.57* 25%)) = $538.95