Approximately 14 million Americans are addicted to drugs and

Approximately 14 million Americans are addicted to drugs and alcohol. The federal government estimates that these addicts cost the U.S. economy $300 billion in medical expenses and lost productivity. Despite the enormous potential market, many biotech companies have shied away from funding research and development (R&D) initiatives to find a cure for drug and alcohol addiction. Your firm – Drug Abuse Sciences (DAS) – is a notable exception. It has spent $165 million to date working on a cure, but is now at a crossroads. It can either abandon its program or invest another $45 million today. Unfortunately, the firm’s opportunity cost of funds is 7 percent and it will take another five years before final approval from the Federal Drug Administration is achieved and the product is actually sold. Expected (year-end) profits from selling the drug are presented in the accompanying table.

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

$0

$0

$0

$0

$12,300,000

$14,500,000

$17,100,000

$18,500,000

$20,300,000

Solution

The existing amount of $165 million that is already spent is a sunk cost and not a relevant cost.

PW of expected profits ($ Million) = 12.3 x P/F(7%, 5) + 14.5 x P/F(7%, 6) + 17.1 x P/F(7%, 7) + 18.5 x P/F(7%, 8) + 20.3 x P/F(7%, 9)

= 12.3 x 0.7130** + 14.5 x 0.6663** + 17.1 x 0.6227** + 18.5 x 0.5820** + 20.3 x 0.5439**

= 8.77 + 9.66 + 10.65 + 10.77 + 11.04

= 50.89

Since PW of expected future profits is higher than $45 million, this investment should be made.