A candidate drug requires an $18 million investment for phase II clinical trials. If the trials are successful (44% probability), the company will learn the drugs scope of use and update its forecast of the drugs PV at commercial launch.

The investment required for the phase III trials and prelaunch outlays is $130 million. The probability of success in phase III and prelaunch is 80%. Launch comes three years after the start of phase III if the drug is approved by the FDA. The probabilities of the upside, most likely, and downside outcomes are 25%, 50%, and 25%, respectively. If the phase III trials are successful, the manager will learn the commercial potential of the drug, which will depend on how widely it can be used. Suppose that the forecasted PV at launch depends on the scope of use allowed by the FDA. These are an upside outcome of NPV = $700 million if the drug can be widely used, a most likely case with NPV = $300 million, and a downside case of NPV = $100 million if the drugs scope is greatly restricted. We assume a risk-free rate of 4% and market risk premium of 7%. Assume FDA-approved pharmaceutical products have asset betas of 0.8 and the opportunity cost of capital is 9.6%. Accordingly, the NPV works out to $19 million. The R&D team has put forward a proposal to invest an extra $20 million in expanded phase II trials. Phase II takes two years. The object is to prove that the drug can be administered by a simple inhaler rather than as a liquid. If successful, the scope of use is broadened and the upside PV increases to $1 billion. The probabilities of success are unchanged. Use Figure 10.7.

a-1. Calculate the NPV. (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

a-2. Is the extra $20 million investment worthwhile? (yes or no)

b-1. Assuming that the probability of success in the phase III trials falls to 75%, recalculate the NPV with the extra 20 million investment. (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

b-2. Is the extra $20 million investment worthwhile? (yes or no)

Please show as much work as you can! Thank you.

Phase III Trials and prelaunch (3 years) Invest 130? Succeed 80% Upside PV = 700 Phase Il Trials, 2 years Yes, NPV = +295 20% Fail, PV = 0 Learn potential PV 25% Invest 130? 50% Succeed 44% Succeed 80% Most likely PV = 300 Invest 18? Yes, NPV = +52 56% 20% Fail, PV = 0 Fail PV = 0 25% Invest 130? Succeed 80% Downside PV = 100 STOP, PV = 0 20% Fail, PV = 0 FIGURE 10.7 A simplified decision tree for pharmaceutical R&D. A candidate drug requires an $18 million investment for phase Il clinical trials. If the trials are successful (44% probability), the company learns the drug's scope of use and updates its forecast of the drug's PV at commercial launch. The investment required for the phase III trials and prelaunch outlays is $130 million. The probability of success in phase III and prelaunch is 80%