Cash Flow at Risk

Good day to all the loyal followers of my blog. Although you currently number less than one, it's comforting to know that you all come to me for your risk management knowledge. Today we're going to look more at the variables in the net present value equation and the increased risk to a firm when adding new projects. In an example in class we had a pharmaceutical company that is considering the introduction of a new drug. There is, of course, litigation risk. The cost of the drug is $100M and expected revenue for year one is $140M. The standard deviation of current drug earnings is $25M and $20M for the new drug. The cost of capital is 6%, the marginal cost of holding risk capital is 11%, and the correlation between the new and existing drugs is 25%. Here we look at the 95% level and find that CaR is $41M currently and $59M when the new drug is added. Thus, the NPV is (140/1.06)-100-.11(59-41)=$30.13M.
Now let's assume that three things have changed from above but the rest has remained the same. Expected revenue in year one is now $106, the cost of capital has dropped to 5%, and we're going to look at the 99% level. The 99% level means in this case that we are looking at the worst loss in cash flow we could expect one percent of the time. The net present value in this case would be (106/1.05)-100-.11*((59*2.326)-(25*2.326))=-1.8M. If we ignored the increased risk to the company, then the NPV would be a positive $1M and the new drug would be added. But since we need to consider the added risk, this new drug would not be added. Also, I looked at the same numbers but at the 95% level and that alone reduced the NPV by $800K. So, it depends on what level we want to be protected at.