Start Gen Inc. is a new company whose only asset is a patent on a new drug. Curr

Question

Start Gen Inc. is a new company whose only asset is a patent on a new drug. Current risk-free rate is 8%, but it can either go up to 10% or go down to 5% after one year and will stay at that level for ever. The life of the patent is 17 years and it takes $10 million to construct the plant that will produce the drug. The net annual operating cash flow (including depreciation tax shield) from the drug will be $1 million for each of the years of its patent life. After the patent expires the cash flow will be zero due to competition from generic drug makers. Firm can either start the production immediately or wait for one year to start the production. What is your advice to this firm on when to start production? (Assume that the risk-free rate is the same as the cost of capital).

Explanation / Answer

He should wait and watch if interest rate goes down to 5% and start business next year as the net present value both at 8% and 10% is negative.

Particulars Year Amount PV@10% PV@5% PV@8% Initial Investment 0 -10 -9.091 -9.091 -10 Cash Inflow annuity for 17years 1-17 Interrest Factor=F=(1+i)^n ,where i=interest,n=years 5.054 2.292 3.700 PV of annuity A=1m for 17 Years=A*((F-1)/i*F)) 8.022 11.274 9.122 Net PV -1.069 2.183 -0.878

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