Erin Mills Pharmaceuticals is considering investing in developing a new drug. A preliminary (testing) phase will last two years and will cost $5 million today. There is a 50% chance that the test will prove successful and a 50% chance of failure. The test results will be known two years from today. The production phase can begin after the preliminary (testing) phase and will cost $8 million two years from today with production over the following six years. Expected sales level are 8 million units per year (i.e. if tests are successful) and 1 million units per year (i.e. if tests are unsuccessful). The sales price is $11/unit and variable cost is $7/unit. Fixed costs are $3 million per year. The tax rate is 30%, discount rate is 8% and depreciation rate is 0%. (Note: You can assume end of year cash flows.)

Draw the decision tree and identify the cash flows.

Should the company invest in developing the new drug with the option to invest or not in production? (Please justify by calculating the NPV today with and without the option to produce)

What is the value of the option to invest or not in production as of time t = 0?