A pharmaceutical drug is currently undergoing testing. The three-stage FDA approval process lays out the hurdles that have to be passed for this drug to be commercially sold, and failure at any of the three stages dooms the drug's chances.

This pharmaceutical drug treats Type I of a disease and has gone through pre-clinical testing and is about to enter Phase 1 of the FDA approval process:

Phase 1

Phase 1 is expected to cost $50 million and will involve 100 volunteers to determine safety and dosage; it is expected to last 1 year.

There is a 70% chance that the drug will successfully complete the first phase.

Phase 2

In Phase 2, the drug will be tested on 250 volunteers for effectiveness in treating the disease over a two-year period.

This phase will cost $100 million and the drug will have to show a statistically significant impact on the disease to move on to the next phase.

There is only a 30% chance that the drug will prove successful in treating Type I but there is a 10% chance that it will be successful in treating both Type I and Type II, and a 10% chance that it will succeed only in treating Type II.

Phase 3

In Phase 3, the testing will expand to 4,000 volunteers to determine the long-term consequences of taking the drug.

If the drug is tested on only Type I or Type II patients, this phase will last 4 years and cost $250 million; there is an 80% chance of success.

If it is tested on both types, the phase will last 4 years and cost $300 million; there is a 75% chance of success.

If the drug passes through all 3 phases, the costs of developing the drug and the annual cash flows are provided below:

Disease Treatment	Cost of Development	Annual Cash Flows
Type I	$500 million	$300 million for 15 years
Type II	$500 million	$125 million for 15 years
Type I and Type II	$600 million	$400 million for 15 years

 

ASSUMPTIONS

 

Use the following assumptions in your decision analysis:

The cost of capital is 10%.

The cost of each phase is incurred in the beginning of each phase.

Since these phases take time, you must consider time value of money.

 

QUESTION:

What are the decision alternatives and states of nature for this problem? Draw a decision tree that includes a full (unreduced) decision tree that shows all of the following:

The logical sequence of the decision problem,

The payoff at every terminal node,

The decision nodes,

The chance nodes, and

The probabilities

Include a backward induction