Financial Markets and Institutions Problem Set

AEM 4590

Problem set 2

Question 1 – PV, near term project

To determine whether a project is worth undertaking, a company manager performs a cash flow analysis and summarizes his findings in the following table (in millions).

1a. Assuming the company’s cost of capital is 10%, should this project be done? (Use NPV analysis).

-1000 + (770)/(1.1) + (242)/(1.12) + (532.4)/(1.13) = 300

The NPV is positive, so this project should be done

1b. The vice president of the company wants to know the IRR of the above project. Write down the equation that the manager needs to solve to find the IRR (don’t solve it, just write down the equation).

NPV = ∑_(n=0 )^N▒C_n/〖(1+IRR)〗^n = 0

Solve for IRR

Cn represents the cash flow at any time, n

1c. Not knowing how to solve an n-degree polynomial equation, the manager tells his assistant to work on this “trivial” problem. You are his assistant. Using a spreadsheet program (or calculator), find the IRR. (You can do this very easily in Excel by using the “IRR” function)

The IRR is 28.24%

Answer found using Excel

Question 2 – PV, Long term project

Now, suppose the project is long term and has much later payoff dates. But there is a huge terminal value of 800 million dollars in year 11. The drug company performs a cash flow analysis and summarizes his findings in the following table (in million’s).

2a. Assuming the company’s cost of capital is 10%, should this project be done? (Use NPV analysis).

-1000 + (770)/(1.18) + (242)/(1.19) + (532.4)/(1.110) + (800)/(1.111) = -52.5

The NPV is negative, so this project should not be done

2b. What is the present value of the project?

The PV is -52.5 + 1000 = 947.5 million dollars

2c. Find the IRR of this project.

The IRR of this project is 9.4%

Question 3 – Development of a Drug

A scientist Dr Cai is developing a drug compound A that has potential to slow the growth of cancer cells in the brain. It’s still in early stage. As of now, the probability of successful FDA approval for compound A is 0.05%. If the drug passes, the sales of the compound will be worth $2.5 billion dollars in current present value. If the drug fails, it will be worth $0. The current investment is 100 million. Hence, the return in the case of the drug passing (P) is: (2500-100)/100 = 24.

The scenario can be summarized as below (in millions)

Drug A initial investment 100

Scenario Probability Payoff Returns

F 95% 0 -1

P 5% 2500 24

What is the expected returns of this investment?

(.95)*(-1)