Question

1) ABC Pharmaceuticals, a large pharmaceutical company headquartered in the Midwest wants to build a new ethanol facility in Nebraska in order to support future increases in demand. The management team of ABC Pharmaceuticals is presented with two different scenarios for its new ethanol facility and will choose the scenario with the greatest net present value.

• Scenario A: To have the new ethanol facility up and running in 1 year, ABC Pharmaceuticals must invest $2 billion now and will expect profits of $750 million, $600 million, $500 million, $400 million and $300 million in years 1, 2, 3, 4 and 5, respectively.

• Scenario B: To have the new ethanol facility up and running in 2 years, ABC Pharmaceuticals must invest $1 billion now and $500 million in year 1 and will expect profits of $525 million in years 2, 3, 4 and 5, respectively.

What are the net present values of the two scenarios? Assume ABC Pharmaceuticals has a 6% cost of capital (discount rate). (Note: Your answer should be expressed in units of millions of dollars.)

NPV Scenario A = $ ____million

NPV Scenario B = $_____million  

2)

Congratulations! The FDA has just approved your company's new drug, and now ABC Pharmaceuticals wants to buy its North American marketing rights. Before you decide whether to sell, you must assess the four payment plan options offered by ABC Pharmaceuticals:

• Option A: Receive annual payments of $25 million forever.

• Option B: Receive annual payments forever starting at $15 million and increasing each year with the inflation rate of 3% per year.

• Option C: Receive 25 annual payments of $27.5 million.

• Option D: Receive 25 annual payments starting at $22.5 million and increasing each year with the inflation rate of 3% per year.

What is the present value of each option? For each payment plan option, assume the first payment would begin one year from today, and that the nominal discount rate is 10% per year. (Note: Your answer should be expressed in units of millions of dollars.)

NPV Option A = $____million

NPV Option B = $____million

NPV Option C = $____million

NPV Option D = $____million

For Option D, note that the present value of a growing annuity that pays ? dollars starting one year from now with subsequent annual payments that grow at a rate ? is given by,

??(?)=??−?×[1−(1+?1+?)?]

where ? is the discount rate and ? is the time until the last payment. Optional: Can you derive this formula? Think about subtracting a growing perpetuity that starts paying out in year ?+1 from a growing perpetuity that starts paying out 1 year from today.

Answer 1

Compute the net present value for scenario A, using MS-excel as shown below:

F B C D E 3 Net Present Value (Scenario A) (S in million) 4 Years Particulars Amount PVIF Present Value 50 Cash outflow -2000 =POWER(1/1.06,B5) =D5*E5 61 Cash inflow 750 =POWER(1/1.06,36) =D6*E6 Cash inflow 600 =POWER(1/1.06,B7) =D7*E7 8 3 Cash inflow 500 =POWER(1/1.06.B8) =D8*E8 Cash inflow 400 =POWER(1/1.06,B9) =D9*E9 5 Cash inflow 300 =POWER(1/1.06,B10) =D10*E10 7 | 11 12 Net Present Value =SUM(F5:F10)

The result of the above excel table is as follows:

B C D Ε 3 Net Present Value (Scenario A) (S in million) 4 Years Particulars Amount PVIF Present Value O Cash outflow ($ 2,000) 1($ 2,000.000000) 6 1 Cash inflow $ 750 0.943396226 $707.547170 2 Cash inflow $ 600 0.88999644 $ 533.997864 8 3 Cash inflow $ 500 0.839619283 $ 419.809642 4 Cash inflow $ 400 0.792093663 $ 316.837465 10 5 Cash inflow $ 300 0.747258173 $ 224.177452 7 9 12 Net Present Value $ 202.369592

Hence, the NPV of scenario A is $202.369592.

Compute the net present value for scenario B, using MS-excel as shown below:

B C D F 15 Net Present Value (Scenario B) ($ in million) 16 Years Particulars Amount PVIF Present Value 170 Cash outflow -1000 =POWER(1/1.06,B17) =D17*E17 181 Cash outflow -500 =POWER(1/1.06,B18) =D18*E18 192 Cash inflow 525 =POWER(1/1.06,B19) =D19*E19 203 Cash inflow 525 =POWER(1/1.06,B20) =D20*E20 21 4 Cash inflow 525 =POWER(1/1.06,B21) =D21*E21 Cash inflow 525 =POWER(1/1.06,B22) =D22*E22 24 Net Present Value =SUM(F17:F22)

The result of the above excel table is as follows:

17 18 в с D E 15 Net Present Value (Scenario B) (S in million) 16 Years Particulars Amount PVIF Present Value O Cash outflow ($ 1,000) 1($ 1,000.000000) 1 Cash outflow ($ 500) 0.943396226 ($ 471.698113) 19 2 Cash inflow $525 0.88999644 $ 467.248131 3 Cash inflow $ 525 0.839619283 $ 440.800124 4 Cash inflow $ 525 0.792093663 $ 415.849173 5 Cash inflow $ 525 0.747258173 $ 392.310541 22 24 Net Present Value $ 244.509855

Hence, the NPV of scenario B is $244.509855.