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Akba Pharma has just completed the laboratory research on a new drug which is expected to cure boredom. So far, $100 million has been spent

Akba Pharma has just completed the laboratory research on a new drug which is expected to cure boredom. So far, $100 million has been spent on research and development.

Before the investment in plant, the drug will now be tried on volunteers. This phase will cost a further $200 million. The chances of a positive result from this phase are 50%. If the results are positive, Akba will receive a patent and will start producing the drug in a new factory. If the results are negative Akba will terminate the project and will not make the investment in plant.

The cost of investment in the new factory is $500 million. The factory investment will be depreciated over 5years to a book value of zero. The patent of the boredom drug will expire after 5 years. After the patent expires, the production of the drug will no longer be profitable for Akba and production will be stopped. The factory however will be sold for $100 million.

Variable production costs are expected to be 20% of sales. Working capital required for each year is expected to be 20% of next years revenues. Akba Pharma expects the following sales revenues from the boredom new drug.

Revenues ($million)

Year1

300

Year2

500

Year3

700

Year4

700

Year5

500

The tax rate for Akba Pharma is 30%. The cost of capital for this project is 15%.

Design a separate sensitivity and a scenario analysis for this project . Make suggestions to Akba Pharma as to how they should include risk into their investment analysis. (Do not perform the calculations relating to the sensitivity analysis and your scenario analysis. Be sure to indicate the variables that you would include in these analyses. Clearly describe your scenarios.)

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