Corporate Finance A pharmaceutical Startup has an annual cost of capital of 12% (compounded monthly) andgoes through two stages to develop a drug.Stage 1: At End of Month 0 (“EOM0”), the Startup has no employees, and has to decide whether toinvest $10mm and hire 5 employees (who will conduct research). (Employees receive $9,000monthly salary, paid at the end of each month that they work, so they begin receiving salariesstarting at EOM1.If the startup decided to invest at EOM0 and hired employees, then:Stage 2: at EOM24, after knowing whether the Startup is in State A, B or C , the Startup has to decidewhether to invest $35mm at EOM24 and add 40 employees (for a total of 45) OR to shut down. Ifthe Startup decides to shut down, then existing employees will be fired “with 6 months notice” i.e.they will receive 6 more months of salary (i.e. at EOM25, EOM26, … EOM30). Note that: at EOM0the startup believed that at EOM24 there would be:95% prob of State A: the startup thinks that at EOM48 they could sell the startup for $50 MM4% prob of State B: the startup thinks that at EOM48 they could sell the startup for $400 MM1% prob of State C: the startup thinks that at EOM48 they could sell the startup for $3.5 Bn Questions: What are the NPVs of the Startup a) “at Stage 2” and b) at Stage 1?For the purposes of answering a) “at Stage 2”, assume: the startup invested at EOM0 and isevaluating the NPV at EOM24, but a split second after salaries were paid at EOM24, and a splitsecond before the startup knows whether it is in State A, B or C (and therefore has not yet made adecision whether to invest or shut down).
A pharmaceutical Startup has an annual cost of capital of 12% (compounded monthly) and
goes through two stages to develop a drug.
Stage 1: At End of Month 0 (“EOM0”), the Startup has no employees, and has to decide whether to
invest $10mm and hire 5 employees (who will conduct research). (Employees receive $9,000
monthly salary, paid at the end of each month that they work, so they begin receiving salaries
starting at EOM1.
If the startup decided to invest at EOM0 and hired employees, then:
Stage 2: at EOM24, after knowing whether the Startup is in State A, B or C , the Startup has to decide
whether to invest $35mm at EOM24 and add 40 employees (for a total of 45) OR to shut down. If
the Startup decides to shut down, then existing employees will be fired “with 6 months notice” i.e.
they will receive 6 more months of salary (i.e. at EOM25, EOM26, … EOM30). Note that: at EOM0
the startup believed that at EOM24 there would be:
95% prob of State A: the startup thinks that at EOM48 they could sell the startup for $50 MM
4% prob of State B: the startup thinks that at EOM48 they could sell the startup for $400 MM
1% prob of State C: the startup thinks that at EOM48 they could sell the startup for $3.5 Bn
Questions: What are the NPVs of the Startup a) “at Stage 2” and b) at Stage 1?
For the purposes of answering a) “at Stage 2”, assume: the startup invested at EOM0 and is
evaluating the
second before the startup knows whether it is in State A, B or C (and therefore has not yet made a
decision whether to invest or shut down).
Trending now
This is a popular solution!
Step by step
Solved in 2 steps
