1. A small biotech firm manufactures a drug for treating type I diabetes that has gone through preclinical testing and is about to enter phase 1 of the FDA approval process. You are provided with information on each of the following 3 phases:

Phase 1 is expected to cost $50 million and will involve 100 volunteers to determine safety and dosage; it is expected to last one year. There is 70% chance that the drug will successfully complete the first phase.

In Phase 2, the drug will be tested on 250 volunteers for effectiveness in treating diabetes over a two year period. This phase will cost $100 million, and the drug will have to show a statistical significant impact on the disease to move on to the next phase. There is 30% chance that the drug will prove successful in treating type I diabetes. There is a 10% chance that it will be successful in treating both type 1 and 2 diabetes. There is also a 10% chance that it will success in treating only type 2 diabetes.

In phase 3, the testing will expand to 4000 volunteers to determine the long term consequences of taking the drug. If the drug is tested on only type 1 or type 2 diabetes patients, this phase will last four years and will cost $250 million; there is an 80% chance of success. If it is tested on both types, this phase will last four years and cost $300 million; there is a 75% chance of success.

If the drug passes through all three phases, the costs of developing the drug and the annual cash flows are as shown below:

Disease treatment Cost of Development Annual CF for the next 15 years.

Type 1 diabetes only $500 million $300 million per year for 15 years

Type 2 diabetes only $500 million $125 million per year for 15 years

Type 1 and 2 diabetes $600 million $400 million per year for 15 years

Using Excel, please analyze the potential profitability of this new drug if the cost of financing (i.e., the cost of capital) for this new drug is 10%.