New expected revenue = 106, Cost of capital = 0.05, 99% confidence level CaR (z=2.326). Should the pharmaceutical company invest in the new drug?
Calculate CaR with 99% confidence:
- 2.326*20=46.52 (new)
- 2.326*25=58.15 (current)
- 2.326*35= 81.41 for combined(calculated by finding the variance of the cash flows, taking the square root and then multiplying by Z=2.326)
Calculate PV of cash flows:
- New drug=106/(1.05)-100=0.9524
The new drug also increases firm risk:
- 106/1.05-100-.11*(change in CaR from old to new) = 106/1.05-100-.11*(81.41-58.15)=-1.6062
If introducing this new product did not create extra risk to the firm, it would be wise of the company to invest in the new drug since it has a positive NPV. But when risk is also taken into account, the NPV changes to less than zero, meaning that this investment will not be profitable and the company should not invest in the new drug.
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