Drugco has just begun Phase III trials for Newdrug. For simplicity, we assume that we are sure

Question:

Drugco has just begun Phase III trials for Newdrug. For simplicity, we assume that we are sure the drug has no side effects, so all that matters for FDA approval is its efficacy.

Efficacy is distributed E ~ U[0, 1] and will be learned during three years of Phase III trials. The NPV of the drug after three years is $1B * E. The discount rate is equal to the riskfree rate of 5 percent per year. The total cost of R&D is $100M and must be paid at the beginning of development.

(a) Draw an event tree for the Newdrug project.

(b) What is the NPV of Newdrug if efficacy is set equal to its expected value?

(d) On average, will the answer to part (b) be different than the answer to part (c)?

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