Hello, 
Assume that you are the CFO Godin Corporation. You are considering an R&D project with an initial investment in pharmaceutical research in order to produce a neurobiological health product. If this investment is successful, you should make further investments in development: that is, various kinds of clinical testing. The drug can be evaluated in a single trial phase. Finally, if the health product proves to be safe and efficient, you will then have to make investments to produce and market it.
The initial outlay of this project that mainly consists in R&D costs is worth of $7 million and has to be paid at date 0. If this initial research phase is undertaken, there are three possible outcomes. The probability that each of the outcomes really occurs has been estimated from similar research projects in the past. More precisely, there is a 9% probability to create a highly efficient neurobiological health product, there is also a 16% probability to find a moderately efficient one and there is a 75% probability that the R&D phase fails.
If the initial research phase is successful, you will have to invest at date 1 in the development phase that will cost $30 million. If this development phase is undertaken there are two possible outcomes. Either your neurobiological health product will pass the safety tests of the Food and Drug Administration (FDA) (with an estimated probability of 45%) or it will fail them (with a 55% probability). Those probabilities hold whatever the efficiency of the health product. Notice that if the product fails to pass the safety tests, the project will not generate any Cash-Flows.
Finally, if your neurobiological health product has passed the safety tests of the FDA, you can produce and market it. A consulting company has estimated that a highly efficient health product would allow you to get, starting at period 3, a yearly FCF of $55 million for perpetuity. A moderately efficient health product would only allow you to get, starting at period 3, a yearly FCF of $30 million for perpetuity. Whatever the efficiency of your health product, in order to produce and market your health product, you will have to build factories and facilities. Those costs are worth off $250 million and have to be incurred at date 2.
You have estimated that the cost of capital for this project is 10% and that it will remain constant over all the period.
As a consequence, you have the following five potential outcomes if you invest in the project:
• Either the R&D phase fails,
• Or the R&D phase is successful and you create a highly efficient neurobiological health product that would successfully pass the safety tests of the FDA,
• Or the R&D phase is successful and you create a highly efficient neurobiological health product that fails to pass the safety tests of the FDA,
• Or the R&D phase is successful and you create a moderately efficient neurobiological health product that would successfully pass the safety tests of the FDA,
• Or the R&D phase is successful and you create a moderately efficient neurobiological health product that fails to pass the safety tests of the FDA.
- Compute the expected NPV of the project without real options. You may consider all the scenarios; compute the Present Value of the Cash-Flows for each scenario and finally, the expected NPV.
- Compute the expected NPV of the project including real options. The Real option embedded in this project is the possibility not to invest the $30 millions at date 1 at the development phase if the expected NPV of a moderately efficient neurobiological health product is negative (including the probabilities of the scenarios 4 and 5: i.e. that it passes the FDA test or not).
Here is it what I did :
a) If The R&D phase fails : PV = 0 and NPV=0
b) If the R&D phase is successful and you create a highly efficient neurobiological health product that would successfully pass the safety tests of the FDA : PV = (55/10%)/(1.1)²= 454.5455M
c) If the R&D phase is successful and you create a highly efficient neurobiological health product that fails to pass the safety tests of the FDA : PV = 0
d) If the R&D phase is successful and you create a moderately efficient neurobiological health product that would successfully pass the safety tests of the FDA: PV= (30/10%)/(1.1)²=247.9339M
So the NPV1 of a highly efficient neurobiological health product is : 454.5455 - 250 - 30= 174.5455M
The NP1 of moderately efficient neurobiological health product is : 247.9339 - 250 - 30 = -32.0661M
Expected NP1 of the project is : (174.54559%) + (-32066116%)+(0*75%) = -51290.05M
NP0 is : -7- (51290.05/1.1) = -46634.31M. I’m not sure if what I did is correct
- I’m completely lost on the 2nd question. Could you please help me. Thanks in advance
Good luck to everyone in the exam
