July 2018 Fin 338 Name: Quiz 10 A project with an up-front cost at t-0 of $1500

Question

July 2018 Fin 338 Name: Quiz 10 A project with an up-front cost at t-0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product that is now under development is approved by the Food and Drug Administration. If the FDA rejects the competitive product upon the completion of its development, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t-1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t 1 to 7). NPC will know only sometime later whether the competitor's product is going to be approved. NPC will proceed with the investment today to take advantage of the untapped market potential and at the end of the project's life, after finding out about the FDA's decision about the competitor's product, they will decide whether or not to renew the patent and rerun the project. The project rerun's up-front cost (at t- 7) will remain at $1,500, and the subsequent cash flows will remain unchanged and will be received for seven additional years (t-8 . only rerun the project if the rerun of the project adds value. 14). They will Assuming that all cash flows are discounted at 10%, what is the NPV of the project with and without the growth option?

Explanation / Answer

expected cash flows = 0.75*500 + 0.25*25 = 381.25

NPV = 182.73 so accept

Discount rate 10.0000% Cash flows Year Discounted CF= cash flows/(1+rate)^year Cumulative cash flow                              -   0                                            -                                           -                                -   1                                            -                                           -                                -   2                                            -                                           -                                -   3                                            -                                           -                                -   4                                            -                                           -                                -   5                                            -                                           -                                -   6                                            -                                           -              (1,500.000) 7                                 (769.74)                             (769.74)                  381.250 8                                   177.86                             (591.88)                  381.250 9                                   161.69                             (430.19)                  381.250 10                                   146.99                             (283.21)                  381.250 11                                   133.63                             (149.58)                  381.250 12                                   121.48                                (28.10)                  381.250 13                                   110.43                                  82.33                  381.250 14                                   100.40                                182.73

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