Nucleon is trying to determine whether to produce a new drug that makes pigs healthier. The product will be sold in the years 2007 to 2011. The following information is relevant: ■ A fixed cost is...

Nucleon is trying to determine whether to produce a new drug that makes pigs healthier. The product will be sold in the years 2007 to 2011. The following information is relevant:


■ A fixed cost is incurred on 1/1/2006 and will be between $1 billion and $5 billion. There is a 20% chance the fixed cost will be less than or equal to $2 billion, a 60% chance that it will be less than or equal to $3 billion, and a 90% chance that it will be less than or equal to $4 billion. The fixed cost is depreciated on a straight-line basis during years 2007 to 2011.


■ The weighted average cost of capital is 15%. This is the rate Nucleon uses for discounting cash flows.

■ The market size in 2007 is 10 million pigs.

■ During each of the years 2008 to 2011, the market size will grow at the same rate. This growth rate is assumed to follow a triangular distribution with best case 15%, most likely case 6%, and worst case 1%.


■ The selling price is always $100 per unit, and the unit cost of production is always $16 per unit.


■ In 2007, the average number of units of the drug sold for each pig will be between 1 and 2, with 1.3 and 1.7 being equally likely, and 1.5 being twice as likely as 1.3.


■ There are three potential competitors. During each of the years 2007 to 2011, a competitor who has not entered the market has a 60% chance of entering the market.


■ The year after a competitor enters the market, the average units sold per pig of the Nucleon drug drops by 20% for each competitor entering. For example, suppose that sales per pig are 1.5 units in 2007. If two competitors enter the market in 2007, Nucleon sales per pig drop to 0.9 in 2008.

■ All cash flows other than the fixed cost on 1/1/2006 are incurred midyear.

Use simulation to model Nucleon’s situation. Based on the simulation output, would you go ahead with this project? Explain why or why not? What are the three key drivers of the project’s NPV? (Hint: The way the uncertainty about the fixed cost is stated suggests using the Cumul distribution from Section 11.3 in Chapter 11. Similarly, the way the uncertainty about the units sold per pig in 2007 is stated suggests using the General distribution from Section 11.3 in Chapter 11.)