Suppose a firm is contemplating investing in a new distribution network to distribute over-the-counter drugs to pharmacies around the world. Also, suppose that the investments and cash flows from creating this distribution network are as depicted in panel A of the following table. Finally, suppose that this distribution network, with some additional investment, could also be used to distribute prescription drugs, and the investments and cash flows of this second investment are as depicted in panel B. Assume that the discount rate for these two investments is 13%.

First, what real options are embedded in the investment in the over-the-counter distribution network? Given the investments and cash flows, what is the exercise price, the value of the underlying asset, and the time to maturity of these options? Assume the risk-free rate of return is 5.5% and the level of uncertainty of the cash flows associated with investing in a prescription drug network is .25. What is the value of creating a new over-the-counter distribution network without considering the possibility of also creating a prescription drug distribution system? What is the value of this real option? Given these numbers, should this firm invest in the over-the-counter distribution network?

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0 1 2 (A) Cash Flows from Investing in an Over-the-Counter Drug Distribution Network Year 34 Cash Flow 0 7.0 6 7 8 8.5 11.2 11.3 12.0 12.3 5 12.4 13.0 Terminal Value 87.8 Investment (72.0) (B) Cash Flows from Investing in a Prescription Drug Distribution Network Year 0 1 2 3 4 5 6 7 8 Cash Flow 0 0 0 0 0 32.4 48.2 65.7 68.4 Terminal Value 428.3 Investment (275)