I Wish I Had a Crystal Ball

Richard Ponting could feel the pressure as he walked into the executive boardroom with his briefcase containing the data and slides pertaining to his latest proposal. The last couple of years had not been very good for him. Two of the projects that he had recommended for investment ended up having to be abandoned, and one that he had turned down ended up being a winner for one of the firms main competitors. Richard knew that this was going to be a long meeting. Richard, the product development manager for Advanced Pharmaceuticals, had joined the firm about seven years ago. With a bachelors degree in chemistry and an MBA in finance from a nationally recognized university, Richard had been fairly successful in his professional career. Prior to working at Advanced Pharmaceuticals, Richard had been responsible for launching three highly successful drugs at another mid-sized pharmaceutical company. It didnt take long for the headhunters to find him, and shortly thereafter Advanced Pharmaceuticals made him an offer that was too good to refuse. At Advanced, however, his track record was not as good. Three of his last five recommendations had cost the company some serious money and Richard knew that this time his job was on the line. He remembered how last night as he was putting the finishing touches to his presentation he kept saying to himself, I wish I had a crystal ball. Advanced Pharmaceuticals, headquartered in Deerfield Beach, Florida, was a fairly large pharmaceutical company that had a number of patented drugs under its belt. However, two of the patents of its bestsellers had recently expired, and generic drug manufacturers were chipping away at its profits. Although the company had employed a number of excellent research scientists and technicians and had a number of projects in the pipeline, the stock price had tumbled during the past year mainly due to the lackluster performance of a couple of drugs that were expected to be block-busters. One major problem facing the pharmaceutical industry was the difficulty of making reasonably accurate risk/return projections, primarily stemming from the requirement of obtaining approval from the Food and Drug Administration (FDA) prior to marketing the drug. In the past, overconfidence on the part of the folks in marketing and strategic planning had resulted in some rash and unprofitable decisions.The vision research division of the company had developed a new drug, ClariVision, for the cure of myopia, which had shown tremendous promise in preliminary tests. The project leader, Tony Dunn, was confident that the drug would revolutionize the world of ophthalmology. Richard had carefully analyzed the cost and revenue estimates that were presented to him (see Table 1). Based on the figures provided by the project team, Richard calculated the net present value and internal rate of return of the project. The numbers looked good. However, Richard had learned from his earlier mistakes that one cannot take cost and revenue estimates at face value. Accordingly, he prepared a scenario analysis of the ClariVision project by varying the marketing costs, testing costs, and market share to reflect the best case, worst case, and most likely case scenarios, respectively (see Table 2). My analysis shows that the outcome of the project depends heavily on the degree of market penetration achieved by the firm, said Richard. A slight drop in market share accompanied by a 10% increase in testing and marketing costs (worst case) tends to make the NPV negative. However, if we can keep the testing and marketing costs at $110 million or less and have market penetration of 8% or more, the project will be profitable. I think given the strategic nature of this product, we should go ahead with it. I have a strong feeling that this ones a winner. As soon as Richard had finished his presentation, Adrian Jennings, the youngest director on the board, raised the question, Have you considered the possibility that we may not get FDA approval within one year, if at all? What do we do then? Richards worst fears had come true. He had seen this coming. Thats a risk we have to live with, Adrian, he said. But I am willing to go back and rework the numbers assuming a one- or two-year delay in getting FDA approval. Will that help? It certainly will, said Adrian, I guess thats the best we can do since we dont have a crystal ball, right?

Table 1

Cash Flows, NPV and IRR Analysis of ClariVision Project (Most Likely Case)

(Millions)		0	1	2	3	4	5	6	7	8	9	10
Development Costs		?80
Testing Costs		?10
Marketing Costs		?100
Total Cost		?190
Population with Myopia		40	41.2	42.4	43.7	45.0	46.4	47.8	49.2	50.7	52.2	53.8
Growth Rate of Population with Myopia	3%
Cash Flow on Dosages Sold:
Market Share	8%		3.30	3.39	3.50	3.60	3.71	3.82	3.94	4.05	4.18	4.30
Net Cash Flow if Approved @$10/Customer	$10	?190	$32.96	$33.95	$34.97	$36.02	$37.10	$38.21	$39.36	$40.54	$41.75	$43.01
IRR	14%
Cost of Capital	12%
NPV	$17.76

Table 2

Scenario-Based Assumptions Regarding Cost Estimates

and Market Share for ClariVision Project

	Testing Costs	Marketing Costs	Market Share
Worst-Case Scenario	$11 million	$110 million	6%
Most Likely Case Scenario	$10 million	$100 million	8%
Best-Case Scenario	$9 million	$90 million	10%

Table 3

Scenario Analysis of ClariVision Project

	(Millions) Worst Case	(Millions) Most Likely	(Millions) Best Case
Development Costs	$ (80)	$ (80)	$ (80)
Testing Costs	$ (11)	$ (10)	$ (9)
Initial Marketing Costs	$ (110)	$ (100)	$ (90)
Total Cost	$ (201)	$ (190)	$ (179)
Population with Myopia (year 0)	40	40	40
Growth Rate of Population with Myopia	3%	3%	3%
Cash Flow on Dosages Sold:
Market Share	6%	8%	10%
Discounted Net Cash Flows (if approved) @$10/Customer for Years 1 through 10	$ 155.82	$ 207.76	$ 259.69
IRR	6.46%	14.13%	21.66%
Cost of Capital	12%	12%	12%
NPV Questions: (PLEASE ANSWER ALL THE QUESTIONS. EXPLAIN ?AND SHOW WORK) 1.What is a real option? Explain how this project can be viewed as a real option. 2.If you were a director on Advanced Pharmaceuticals board, would you agree with Richard Pontings analysis? Explain. 3.How would the numbers turn out after taking into consideration the contingency that the drug may not be sold until year 2 or 3 due to delay in getting FDA approval? 4.What are strategic options? What kind of strategic options would apply in this case?	$ (45.18)	$ 17.76	$ 80.69