Times are tough for Auger Biotech. Having raised $85 million in an initial publi

Question

Times are tough for Auger Biotech. Having raised $85 million in an
initial public offering of its stock early in the year, the company is
poised to launch its product. If Auger engages in a promotional cam-
paign costing $60 million this year, its annual after-tax cash flow over
the next five years will be only $700,000. If it does not undertake the
campaign, it expects its after-tax cash flow to be minus $18 million an-
nually for the same period. Assuming the company has decided to stay
in its chosen business, is this campaign worthwhile when the discount
rate is 10 percent? Why or why not?

Explanation / Answer

The promotional campaign will result in annual cashflows of 700,000 while NOT having the campaign will result in annual cashflows of -18 million.

So the net effect of the campaign is an annual cashflow of 700,000 - (-18,000,000) = 18,700,000 annually, i.e. 18.7 million

Present value of these 5 year cashflows at a discount rate of 10% = 18.7 / (1+10%)^1 + 18.7 / (1+10%)^2 + 18.7 / (1+10%)^3 + 18.7 / (1+10%)^4 + 18.7 / (1+10%)^5 = 70.89 million

As this is greater than the initial investment of 60 million for the campaign, this means that the campaign is worthwhile.

Hope this helped ! Let me know in case of any queries.

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