Question
Assume that a pharmaceutical company has been approached by an entrepreneur who has patented a new drug to treat ulcers. The entrepreneur has obtained FDA
Assume that a pharmaceutical company has been approached by an entrepreneur who has patented a new drug to treat ulcers. The entrepreneur has obtained FDA approval and has the patent rights for the next 17 years. Although the drug shows promise, it is still very expensive to manufacture and has a relatively small market. Assume that the initial investment to produce the drug is $500 million and the present value of the cash flows from introducing the drug now is only $350 million. The technology and the market are volatile, and the annualized standard deviation in the present value, estimated from a simulation, is 25%. 14 Although the NPV of introducing the drug is negative, the rights to this drug may still be valuable because of the variance in the present value of the cash flow. In other words, it is entirely possible that this drug may not only be viable but extremely profitable a year or two from now. To value this right, we first define the inputs to the option pricing model: Value of the Underlying Asset (S) = PV of Cash Flows from Project if Introduced Now = $350 million Strike Price (K) = Initial Investment Needed to Introduce the Product = $500 million Variance in Underlying Assets Value = (0.25) 2 = 0.0625 Time to Expiration = Life of the Patent = 17 years Cost of delay (Dividend yield in option model) = 1Life of the patent = 117 = 5.88%
Assume that the 17-year riskless rate is 4%. The value of the option can be estimated as follows: Call Value = 350 exp (0.0588)(17) (0.5285) 500 exp (0.04)(17) (0.1219) = $37.12 million Thus, this ulcer drug, which has a negative NPV if introduced now, is still valuable to its owner.
HOW MUCH WOULD YOU PAY FOR THIS OPTION? - Assume that you are negotiating for a pharmaceutical company that is trying to buy this patent. What would you pay? Explain.
- $37.12 million.
- More than $$37.12 million.
- Less than $37.12 million.
- Explain.
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