Second Semester, AY 2013-2014
Approximately 14 million Americans are addicted to drugs and alcohol. The federal government estimates that these addicts cost the US economy $300 billion in medical expenses and lost productivity Despite the enormous potential market, many biotech companies have shied away from funding R&D initiatives to find a cure for drug and alcohol addiction. Your firm DAS (DrugAbuse Science) is a notable exception. It has spent $170 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $30 million today. Unfortunately, the firm’s opportunity cost of funds is 7% and it will take another 5 years before final approval from the Federal Drug Administration is achieved and the product is actually sold. Expected (year-end) profits from selling the drug are presented in the table below. Should DAS continue with its plan to bring the drug to market or should it abandon the project? Explain.
First, note that the $170 million spent are sunk costs, they will be lost regardless of the decision. The relevant question is whether the incremental benefits (the present value of the profits generated from the drug) exceed the incremental costs (the $30 million needed to keep the project alive). Since these costs and benefits span time, it is appropriate to compute the net present value. Here, the net present value of DAS’s R&D initiative is $26,557,759.86
Since this is positive, DAS should spend the $30 million. Doing so adds about $26.6 million to the firm’s value.
As marketing manager for one of the world’s largest automakers, you are responsible for the advertising campaign for a new energy-efficient sports utility vehicle. Your team has prepared the following table, which summarizes the (year-end)