Homework Exercise

Q: Suppose a firm's new expected revenue is 106. The cost of capital is 0.05. And we want to use the 99% confidence level for CaR (use Zc=2.326). Assume everything else the same, should the pharmaceutical company invest in the new drug?

A: The cash flow at risk for this new drug is calculated as follows at the 99% confidence level (1%):
2.326*20=46.52 for new
2.326*25=58.15 for 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 Zc=2.326)

Then the present value of cash flows:
New drug=106/(1+.05)-100=0.9524

We also need to account for the fact that the new drug increases firm risk as well. We must adjust our calculation to account for this increase:
106/(1.05)-100-0.11*(change in CaR from new to old)
=106/(1.05)-100-0.11*(81.41-58.15)
= -1.6062

When using the calculation of NPV without adjusting for firm risk, the new drug's present value of future cash flows was barely positive. When choosing new projects or investments, any project with positive cash flows, NPV, should be chosen. So using this calculation, even though the firm would only earn a little extra cash, the new drug would become a new investment. However, when adjusting for firm risk, the NPV of the new drug became negative. Therefore, the new drug should not be invested in because the net present value of future cash flows is negative, which would increase risk to the firm.