Question

Despite an enormous potential market, many Biotech companies have shied away from R&D funding related to drug and alcohol addiction.

Your firm, D&S, 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. Your opportunity cost of funds is 5%; unfortunately, it will take another five years before final approval from the Food and Drug Administration is achieved and the product is actually sold. Expected year–end profits are shown in the following diagram.   Should D&S continue with the plan to bring the drug to market or should it abandon its plan?

Discuss the relevance, if any, of the $200 million expenditure, to the decision to continue with the program.

1. Year 1             $0
2. Year 2             $0
3. Year 3             $0
4. Year4              $0
5. Year 5             $12million
6. Year 6             $13.4 million
7. Year 7             $17.2 million
8. Year 8             $20.7 million
9. Year 9             $22.45 million

Answer 1

$200  million expenditure before today is sunk cost and will not used in further economic analysis

present cost = 60 m

i = 5%

We will use formula P = F/(1+i)^t to find present value of future cash flow

NPV of the project = -60m + 12m/(1+0.05)^5 + 13.4m/(1+0.05)^6 + 17.2m/(1+0.05)^7 + 20.7m/(1+0.05)^8 + 22.45m/(1+0.05)^9

= -60m + 12m/(1.05)^5 + 13.4m/(1.05)^6 + 17.2m/(1.05)^7 + 20.7m/(1.05)^8 + 22.45m/(1.05)^9

= 0.107364m

NPV is positive

So project should continue with investment of 60 m