A biotech firm must decide whether to purchase the patent to a new food additive

Question

A biotech firm must decide whether to purchase the patent to a new food additive, a low-cal starch substitute. It is estimated that the funds required to bring the additive to the market can be as high as $50 million or as low as $25 million. The payoff is uncertain as well: The present value of profits could be as high as $500 million or as low as $30 million. The risk free rate is %10, and the standard deviation of rate of return on biotech products is 35%. The patents life is estimated at one year

a) In a worst 2013 case scenario, how much is the patent worth?

b) In a best   2013 case scenario ,how much is the patent worth?

Explanation / Answer

: We need to make a few assumptions to solve this problem. We assume that in one year, the present value of profits will take values of $500M and $30M with equal probability. We further assume that the risk-free discount rate is the appropriate capitalization rate for the firm. In a worst-case scenario, the costs will be $50M. The firm will only adopt the project if NPV > 0, or PV(Benefits) = $500M. The expected net present value is 0.5(500

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