A drug company is considering investing $100 million today to bring a weight loss pill to the market. At the end of one year, the firm will know the payoff; there is a 0.50 probability that the pill will sell at a high price and generate $37 million per year of profit forever and a 0.50 probability that the pill will sell at a low price and generate $1 million per year of profit forever. The interest rate is 10%. Suppose the firm decides to wait one year to determine whether the pill will sell at a high or low price. The firm will not invest if it learns that the pill will sell at a low price. What is the net present value of waiting one year to make the investment?

Question

Quizplus · Accepted Answer

The net present value (NPV) of waiting one year to make the investment can be calculated by considering the expected value of the project if the firm waits for one year and then discounts it back to the present value. If the pill sells at a high price, the NPV of the project is the present value of $37 million in perpetuity at a 10% discount rate, which is $37 million / 0.10 = $370 million. If the pill sells at a low price, the firm will not invest, and the NPV is $0. The expected value in one year is thus 0.50 * $370 million + 0.50 * $0 = $185 million. Discounting this back one year at 10% gives an NPV of $185 million / (1 + 0.10) = $168.18 million. Since the firm has to invest $100 million after one year if it decides to proceed, the net present value of waiting is $168.18 million - $100 million = $68.18 million. However, the correct calculation involves recognizing that the NPV of waiting to invest should consider the value of the option to invest only under favorable conditions, which was not accurately reflected in the provided choices or explanation. The correct approach involves calculating the expected NPV of the project if the investment is made immediately and comparing it with the option to wait, but the given choices do not align with this corrected explanation.

A Drug Company Is Considering Investing $100 Million Today to Bring