Karen is the CEO of a pharmaceutical company. She is considering two R&D; projec
ID: 1119747 • Letter: K
Question
Karen is the CEO of a pharmaceutical company. She is considering two R&D; projects: Drug A and Drug B. 7 shows the expected net value in 5-year periods, i.e. expected upfrontcost to develop each drug (periods& expected profits (periods 3-7). Drug A has fewer side effects and will be harder to reproduce by competito the patent expires. Table of R&D; Price and Profits R&D; Price or Profit in millions) Period 0 (discovery) 1 (clinical trials) 2 (FDA approval) 3 (monopoly 4 (monopoly) 5 (monopoly) 6 (monopoly) 7 (competitive market) Drug A - $100 -$115 $1 $60 $70 $80 $90 $23 Drug B - $95 -$110 $1 $50 $50 $50 $50 $6 1. How do the options compare in terms of upfront costs and profit? 2, what is the net present value for Drug A if the discount rate is 0%? 3, what is the net present value for Drug A if the discount rate is 10%? 4, what is the net present value for Drug A if the discount rate is 20%? 5. What is the marginal efficiency of capital for Drug A? Page 1Explanation / Answer
1. Not accounting for time value of money, Drug A has higher upfront costs than Drug B. However, Drug A ($107) also has higher profitability than Drug B ($0).
2. when r = 0%, the NPV of drug A can be calculated as sum of discounted cash flows -
3. When discount rate is 10% -
Drug A breaks even at 10% discount rate.
4. When discount rate = 20%
5.
Marginal efficiency of capital for Drug A will be rate of interest that will equate fixed cost of capital to expected income. In this case, it will be 10% (see part 3).
Note:
1. discounted cash flow = (Cash flow in time t)/(1+discount rate)^t
2. NPV = sum of all discounted cash flow
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