Question

Please answer the question step by step. Thank you!

A company got approval to commercialize a new drug to treat Shingles. The following are the key facts: • If the drug passes stage 3 clinical trials, the likelihood it will be a commercial success is 40%. • If the drug is a commercial success, the annual cash flow for the company in each of the next 20 years will be $6 million. • If the drug is not a commercial success, the annual cash flow for the company in each of the next 20 years will be $1.5 million. If the stage 3 clinical trials are a success and a 10% discount rate is applied, what is the NPV of the drug at the start of the commercialization period? Express your answer to the nearest million e.g. $5.2 million should be expressed as 5

Answer 1

Solution:-

To calculate NPV, we must calculate the expected annual cash flows if stage 3 trials are a success as follows:

Expected annual cash inflows= (Annual cash inflow if a commercial success*Probability of commercial success) + (Annual cash inflow if not a commercial success*Probability of not being a commercial success)

Expected annual cash inflows= ($6m*40%) + ($1.5m*60%)= $2.4m + $0.9m = $3.3m

Net present value (NPV)= Expected annual cash inflows*Sum of PV factors for 20 years

Sum of PV factors for 20 years (@10%) = 1/1.1 + 1/(1.1)² + 1/(1.1)³ + 1/(1.1)⁴ +...…………..+ 1/(1.1)²⁰

Sum of PV factors for 20 years (@10%) = 8.514

Net present value (NPV)= Expected annual cash inflows*Sum of PV factors for 20 years

Net present value (NPV)= $3.3m*8.514 = $28 million