Homework Exercise

• Suppose the firm's new expected revenue was 106
• Cost of Capital is 0.05
• And we want to use the 99% confidence level for CaR (hint: use the Zc=2.326)
• Assume everything else is the same, should the Pharmaceutical company invest in the new drug?

The Cash Flow at Risk for this new drug needs to be calculated using the 99% (1%) level:

• 2.326*20=46.52 for new
• 2.326*25=58.15 for current
• 2.326*35=81.41 for combined (calculated by finding the variance of the cash flows, taking the square root, and then multiplying by Zc=2.326)

Then, the present value of cash flows for the new drug is found as follows:

• New Drug=106/(1+0.05)-100=0.9524

However, we also need to account for the fact that the new drug increases firm risk:

• 106/1.05-100-0.11*(change in CaR from new to old)
• =106/1.05-100-0.11*(81.41-58.15)
• = -1.6062

Even without accounting for the increased risk to the firm, the NPV of adding this new drug was barely greater than zero.

By including this factor of added risk, it puts the NPV of this new project less than zero.

Therefore, since adding the new drug would increase risk and result in a negative NPV, we should not engage in this project and should not add this new drug for the pharmaceutical company.