A pharmaceutical company is considering whether to develop a new drug for Covid-19. The company has already spent £2 million on scientific research. The finance director of the company has estimated that it will cost £250, 000 in developing the new drug.

There is a 70% probability that the Independent regulatory body will approve the drug and a 30% probability that the drug will not be approved, and no further expenditure will be incurred.

If the drug is approved the profit from the drug will depend on competition from other pharmaceutical companies.

There is a 50% chance that the competition will be in line with expectations and a profit of £500,000 will be made.

There is a 20% chance that competition be favorable and a profit of £630,000 will be made, and a 30% chance that competition will be adverse and a profit of £100,000 will be made.

Ignore the timing of cashflows and assume a discount rate of zero. The profit figures stated are before taking into account of the development costs of £250,000.

Required:

1. Draw a Decision tree for the above processes indicating the costs, profits, and associated probabilities.

2. Evaluate the proposal using Decision tree analysis and the Expected Value methodology.

3. Calculate the proposal’s standard deviation.

4. Discuss the importance of decision trees and sensitivity analysis to risk management within