Onkology Pharmaceuticals is considering purchasing at most one of two competing drugs (molecules) developed by outside labs to beef up their oncology line. Drug A is from an existing class of drugs that has made it into the marketplace and is therefore considered less risky. Drug B would create a new class of molecules and therefore carries slightly more risk (and greater FDA scrutiny) but also has greater upside. Both drugs have successfully passed Phase II clinical trials, thus only a Phase III clinical trial (testing on humans) remains. If Onkology buys a drug, they will pay for Phase III testing.

The results of the Phase III trials can be classified as "very positive," "positive," or "negative." A negative Phase III result means the drug is worthless. If the results are very positive or positive, Onkology can either seek FDA approval or sell the drug to another company. If Onkology seeks FDA approval, the FDA can either approve or reject the drug. If the FDA approves the drug, Onkology will manufacture/sell the drug and collect all future revenues. If the FDA rejects the drug, Onkology loses their entire investment. The table below summarizes the probabilities, purchase costs, trial costs, sale prices, and future revenues. Assume all $ denominated quantities represent their present values.

TABLE 1 Drug (Molecule) A Drug (Molecule) B Phase III Trial Probabilities Probability Probability Very Positive 0.3 0.2 Positive 0.4 0.3 Negative 0.3 0.5 FDA Approval Rates: Very Positive Phase III Results Probability Probability FDA Approves Drug 0.9 0.8 FDA Rejects Drug 0.1 0.2 FDA Approval Rates: Positive Phase III Results Probability Probability FDA Approves Drug 0.75 0.7 FDA Rejects Drug 0.25 0.3 Costs (Millions) US S US 5 Purchase Drug/Molecule 600 450 Phase III costs 60 75 FDA Review Costs 10 10 Sale Price after Phase III Results (in Millions) USS USS Very Positive Phase III Results 1200 1400 Positive Phase III Results 900 1100 Negative Phase III Results 0 0 Drug Revenues if Produced by Onkology (in Millions) U55 U55 Very Positive Phase III Results 2000 2500 Positive Phase III Results 1300 1800