Question

Approximately 14 million Americans are addicted to drugs and alcohol. The federal government estimates that these addicts cost the U.S. economy $300 billion in medical expenses and lost productivity. Despite the enormous potential market, many biotech companies have shied away from funding research and development (R&D) initiatives to find a cure for drug and alcohol addiction. Your firm – Drug Abuse Sciences (DAS) – is a notable exception. It has spent $200 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $60 million today. Unfortunately, the firm’s opportunity cost of funds is 5 percent and it will take another five years before final approval from the Federal Drug Administration is achieved and the product is actually sold. Expected (year-end) profits from selling the drug are presented in the accompanying table.
Year 1Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
$0 $0 $0$0 $12,000,000 $13,400,000$17,200,000 $20,700,000 $22,450,000
What is the net present value of the project?Should DAS continue with its plan to bring the drug to market, or should it abandon the project?

Answer 1

Answer:

It is more convenient to continue with the project.

Explanation:

Giving the following information:

Drug Abuse Sciences (DAS)has spent $200 million to date working on a cure but is now at a crossroads. It can either abandon its program or invest another $60 million today. Unfortunately, the firm’s opportunity cost of funds is 5 percent.

Year 1= 0

Year 2= 0

Year 3= 0

Year 4= 0

Year 5= $12,000,000

Year 6= $13,400,000

Year 7= $17,200,000

Year 8= $20,700,000

Year 9= $22,450,000

The first relevant information that we need to take into account is that the first 200 million dollars are not relevant, it is a sunk cost. In both options the 200 million remain.

Now, to determine whether to continue or drop we need to calculate the net present value. If it is positive, it is recommendable to continue with the project.

To calculate the net present value we will use the following formula:

NPV= -Io + ∑[Cf/(1+i)^n]

Cf= cash flow

Io= initial investment

For example:

year 5= 12,000,000 /(1.05^5)= 9,402,314

Year 7= 17,200,000/ (1.05^7)= 12,223,719

NPV= 107,364.15

It is more convenient to continue with the project.