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 $280 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $75 million today. Unfortunately, the firm's opportunity cost of funds is 8 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 1 Year 2 $0 $0 Year 3 Year 4 $0 $0 Year 5 Year 6 Year Year 8 Year 9 $15,400,000 $17,500,000 $19,100,000 $22,700,000 $25,900,000 What is the net present value of the project? Instruction: Enter your response rounded to the nearest penny (two decimal places). Use a negative sign (-) where appropriate Should DAS continue with its plan to bring the drug to market, or should it abandon the project? ( (Click to select) )

Answer 1

In the given question, the company already spent $280 million till now. Now the company is thinking to continue or to abandon the project. If the company wants to continue now, an investment of $75 million is required today. In this case the earlier investment of $280 will be considered as a sunk cost. Therefore, it is not taken into account. If the company invests $75 million now, then the benefits will start five years from now. The initial cost will be $75,000,000. The benefits are given as under

Year	1	2	3	4	5	6	7	8	9
Benefits	0	0	0	0	15,400,000	17,500,000	19,100,000	22,700,000	25,900,000

Rate of Interest = 8%

What is the NPV of the project?

NPV = -75,000,000 + 15,400,000 (1 + 0.08) ^{– 5} + 17,500,000 (1 + 0.08) ^{– 6} + 19,100,000 (1 + 0.08) ^{– 7} + 22,700,000 (1 + 0.08) ^{– 8} + 25,900,000 (1 + 0.08) ^{– 9}

NPV = -17,125,831.8

Should the company continue with the plan or abandon the project?

Answer –

The company should ABANDON the project. As the NPV is negative, the company should abandon the project.